Client Letter Excerpts
Excerpts: Letters to Clients
While rocket propulsion is a reasonably exact science, weather forecasting is not. Although it, too, is a physical science, there are just too many variables to consider. As we well know, it’s been said that economics exists in order to make weather forecasters look good. Indeed, weather conditions, especially as they affect crop yields or storm damages, are an input to economic forecasting. While precise GDP forecasting is not possible, there are still many useful things economics can tell us. Simplistically, if we tax something, we’ll get less of it, and if we subsidize something else, we’ll get more of it. Continuing with the simple, there is no free lunch when it comes to government spending and policies. Someone’s got to pay, and politics is mostly about who that someone will be. When taxpayers don’t seem to be paying, frequently everyone pays via inflation.
… suppose John and Jane bought a stock early this year. That stock, representing partial ownership of a company, will provide them, their heirs or new owners usefulness (dividends, for example) over many years. Accordingly, its long-term economic value is unlikely to change a lot over a few months. Nevertheless, stock prices can and do change very significantly over the shorter term. Why’s that? Sometimes business conditions change, but more often than not the sharp price swings we see on a near-term basis are primarily the result of sharp swings in investor sentiment. If there is one point we wish we could imprint in investors’ minds, it’s that there is a strong tendency for swings in sentiment to be much greater than swings in economics or in long-term business conditions. Put differently, investor fears and euphoria both tend to be overblown.
ESG investing has become so popular that many companies are producing their own reports of their contribution to ESG themes. To the surprise of absolutely no one, these reports all conclude that the company issuing its report is among the leaders in pursuing ESG goals. So which companies are really ESG exemplars? That’s a good question, because the economic world is very complex, with counterintuitive conclusions not uncommon.
Because the practice of investing in capitalization-weighted indexes, like the S&P 500, directs more money to the more heavily weighted stocks in indexes, regardless of the merit or valuation of the stocks involved, we’ve expressed concerns that indexing can lead to self-reinforcing stock market bubbles. To date, the popularity of indexing has seemed almost relentless. However, indexing has come up against another powerful trend—the allocation of investment dollars to stocks on an environmental, social and governance (ESG) basis. Put differently, virtually every index includes some unfavored companies on an ESG basis. You simply can’t practice typical indexing and ESG investing at the same time. Although ESG investing has its own problems…, we sense the popularity of ESG investing is growing faster than the popularity of indexing. Ultimately, ESG investing is a subset of active management—where investments are chosen for specific reasons other than their weights in an index.
Of all the money invested in the world, the largest three categories of investments are stocks, fixed-income investments (like bonds and savings accounts), and real estate. Everything else, including gold, jewelry, fine art and various collectibles, amounts to small potatoes and has not historically produced decent returns. In today’s very low interest rate environment, many fixed-income investments will likely return less than the rate of inflation, so this leaves stocks and real estate for those seeking long-term real growth. … Yes, stocks and real estate prices have always been volatile, but it’s this volatility that investors historically have been well compensated to shoulder.
…raters of ESG efficacy have large differences in their ratings of companies like Bank of America, Intel, Comcast, and Samsung, for example. How can this be? One answer is that there is no definitive ESG measure. You can invest in a company on ESG grounds, but don’t leap to the conclusion that any environmental good will come of your investment. Unlike the above companies, there is more general agreement of the seemingly positive ESG attributes of companies like Facebook, Visa and Mastercard. They seemingly don’t hurt the physical environment, but what about breaching individual privacy or enabling the charging of high interest rates to borrowers? Again, these companies and others represent complicated situations that are not easily characterized by simplistic assessments. Unfortunately, this isn’t likely to stop those who feel they can determine how “good” a company may be. … ESG investing can be arbitrary; in some cases it’s more ideological than intelligent; and it may not achieve either the investor’s good intent or expected return.
Importantly, when a company’s stock price becomes incredibly high and ultimately collapses, the company itself might continue to exist and even grow its operational results. For example, Cisco Systems was a leading dotcom bubble stock in the late 1990s, and it still exists today. However, Cisco’s stock price is about 45% lower today than it was in early 2000, over 20 years ago. Ouch! When you start with an exorbitant stock price, there are not a lot of good things that can happen. … We don’t want to see investors who are caught up in a bubble lose their money; however, somebody’s going to be left holding the bag when this tech stock bubble ends. They’re likely to lose money—perhaps a lot of it.
We think the S&P 500 is marching to the beat of a much different drummer this year. The weights of the largest companies in the S&P 500 have increased to the point that the S&P 500 is no longer a reasonable measure of most stock prices or portfolios. It’s in a league of its own, with far above normal concentration in a handful of stocks … When 1% of the S&P 500 companies (Apple, Microsoft, Amazon, Google, Facebook) account for 24% of its weight and produce a year-to-date return through late August averaging about 57% (for the top five companies), it should be clear the S&P 500 is not reflective of the broad stock market. Indeed, the S&P 500 minus its five largest companies has a year-to-date return that’s negative.
We think the growth vs. value pendulum has swung way too far toward growth. Importantly, this isn’t the first time growth-stock prices have become unmoored from reality. Although the timing of historical patterns is not precise, it seems as if growth-vs-value cycles have averaged about 20 years. Indeed, 20 years ago the last major outperformance of growth-style stocks had just peaked after the internet bubble…
The weights assigned the S&P 500’s stocks were once more evenly distributed, but nowadays it has become a much less broadly diversified index. Indeed, it’s possible for the S&P 500 to be up while the majority of stocks are down, or vice versa.
…it’s not unusual to read about the overall market being up or down over a given period. However, finding a good way to measure the market isn’t necessarily easy, especially in recent years. The Dow Jones Industrial Average (the “Dow”) dates back to the 19th century and remains a popular index to this day. It has some technical problems, and therefore most professionals prefer to use the Standard & Poor’s 500 Stock Index. This index contains 500 of the largest companies in America, and one might think it should provide a reasonable measure of the broad stock market. However, due to today’s heavy concentration of index value in a very small number of companies, it’s harder than ever to argue that the S&P 500 is indeed “the market.”
Highly leveraged investments should normally be red flags to most investors. Second, most of the leveraged ETNs were promoted as a means of obtaining higher returns without higher risks or average returns with less risk. This should be a huge red flag. Without the benefit of 20 - 20 hindsight, there simply is no such thing as a high-return, low-risk investment. Investors who think there is are likely misjudging returns, risk, or both. Whenever you see too-good-to-be-true claims, we suggest you run, not walk, from such promotional offerings. In normal times, these investments might not encounter severe difficulties. However, in stressed times—which occur more often than any of us would like—leveraged ETNs and similar investments could cost your investment life.
Other things equal, selling investments that have declined 30% in order to buy those that have only declined 10% simply reduces the recovery potential of one’s portfolio. Again, we’ll sell any company when a reasoned assessment of the outlook has changed sufficiently for the worse. However, history tells us that apart from changed operational outlooks, those stocks that have declined the most will likely rebound the most.
… In the 2007 – 09 financial crisis, U.S. GDP bottomed in June of 2009. If you had known the economy was bottoming exactly at that time (a very unlikely possibility, given the time it takes to gather and report economic statistics), you would have missed the bottom in stock prices (in March of 2009) by three full months. During that three-month period in which stocks were rising, but the economy was still falling, stocks rose at an annualized rate of over 90%. Looking at eight other steep recessions, on average stocks gained at an annualized rate of about 65% between the stock market’s bottom and the eventual end of the recessions. As you can see, it can be quite costly to wait for clear evidence of economic improvement before investing.
A company’s value comes from much more than its earnings this year. When you own a stock, you indirectly own its earnings forever. Recessions come and go, and so do periods of above-average economic growth. This begs a logical question: If recessions produce only slight changes in long-term earnings, why do stock prices typically fall so much in a recession? There are two primary answers: (1) Some investors mistakenly focus intently on current year results, almost to the exclusion of the future, and (2) When investors are gripped with fear, they sometimes do things they’ll later regret—like selling more on emotion than reason. Although every bear market in the U.S. has ended at some point, and all ensuing bull markets have ultimately reached new all-time highs, the force of emotion can be very strong, especially to those who haven’t experienced bear markets before. When other investors act emotionally, the conditions are ripe for patient investors … to take advantage of the bargains presented in a bear market.
In recent weeks, a number of stocks have seen daily price moves of 20+% up and down—sometimes on consecutive days. If such dramatic moves don’t seem crazy, they should. ... Let us repeat: In times like this, we think steep declines in stock prices primarily reflect the resolution of temporary imbalances between buyers and sellers. Most of today’s stock prices, in our view, don’t come close to reflecting long-term economic value. This is nothing new. Stock prices that temporarily disconnect from economic reality have been fixtures of many bear markets.
Some investors are very intelligent people, but they seem unable to control their emotions. Frequently, these people buy investments when they feel confident and sell when they feel worried. If there is a surer way to buy high and sell low, we don’t know what it is. Stock prices are typically low when investors are worried, and they’re high when investors feel euphoric. Realistically, buying low and selling high entails buying in periods of fear—sometimes great fear—and selling in periods of confidence and complacency. Many people find this quite hard to do. That’s one good reason why they should seek experienced counsel.
What is it that allows successful investors to buy in the face of uncertainty? Besides an appreciation of history, it’s confidence in the power of economic progress and entrepreneurship. Time after time, economic progress and entrepreneurship—operating through free markets—have not only overcome uncertainty and fear, but they have often produced new products and processes that ultimately strengthen our economy.
We like to say that if you want to buy low and sell high, the first thing you have to do is buy low—which essentially means buying in times of heightened fears. Run-of-the-mill fears typically won’t get the VIX above 30, much less 40. To get such high readings, investor fears must seem believable. Put differently, if an investor waits until it is obvious that the fear du jour is overblown, then it will be too late to buy near the bottom—the VIX will have already fallen, and stock prices won’t be nearly as attractive as when fears seemed more believable.
Contrary to somewhat popular belief, there is no such thing as “low volatility” stocks. The primary reason is that low volatility in stock price is not an inherent attribute of any given company. Let’s think about utility stocks, for example. Sure, their operational results are apt to be less volatile than for an automobile manufacturer. Moreover, if utility stocks always traded at roughly the same P/E ratio, it does make sense that utility stock prices would likely be less volatile than auto manufacturers. However, if utility stock prices climb sufficiently far above normal, a new component of volatility enters the picture—valuation. Simply put, high valuation (high P/E) stocks tend to be high volatility ones. Thus, as P/Es go higher, so does volatility—apart from the inherent low volatility of the utility business.
Although it is virtually impossible to anticipate short-term stock price swings, certain longer-term trends are much more evident. For example, if all you knew about a stock was its price/earnings ratio (P/E), it turns out you could take advantage of that information. There are always some exceptions to even the most useful generalizations, but based on decades of stock market history, the future performance of the lowest P/E stocks is likely to be better than the future performance of medium P/E stocks, which is likely to be better than the future performance of the highest P/E stocks. Simply put, low P/E stocks (sometimes referred to as “value” stocks) taken as a group typically perform better over the long term. If that’s all you know about investing, you’re off to a good start.
How do we recognize low and high in real time? Also, where are we today as we begin a new decade? Here are our thoughts: First, although there will always be exceptions to any general rule, it’s typically the norm, not exceptions, that powers decade returns. Indeed, too great a focus on exceptions will likely lead to disappointment. Second, “low” and “high” are most effectively determined by stock prices relative to business fundamentals such as revenues, earnings and cash flow per share. For example, prices for high-tech stocks in the late 1990s vastly outpaced their companies’ earnings growth, causing these stocks to become very expensive relative to business fundamentals. Interestingly, while growth stocks were enjoying their time in the sun 20 years ago, value stocks were in the doghouse. Indeed, many investors sold their attractively-priced value stocks (“they never do anything”) to raise funds to chase the stocks that had performed much better in the recent past. Summing up the experience of the last five decades (and longer), strong relative stock returns often lead to high prices, and high prices usually lead to disappointing returns going forward. Correspondingly, relatively weak returns often lead to bargain prices, and bargains typically lead to stronger returns going forward. These conclusions provide the foundation for value and contrarian investing. Investors who can’t understand the relationship between past and future stock returns seem destined to chase their tails. They may even give up on investing in stocks—swearing off something they simply don’t understand.
If you can’t be lucky in investing, it will pay to be a contrarian. Contrarian investing isn’t the same thing as value investing, but it’s a close cousin. Value stocks frequently become values because they are out of favor—and thus inexpensive. Using history as a guide, if an investor routinely bought out-of-favor stocks and sold the popular ones over the last 50 years, he or she would have averaged a higher rate of return than simply owning an index like the S&P 500. The investor would certainly not have been right all the time, but his or her investment batting average would have been high enough to outperform the S&P 500. This result primarily derives from investors’ well-known and well-researched tendencies to become overly enthusiastic regarding popular stocks and overly pessimistic about unpopular ones.
…significant stock price volatility is exactly what has occurred in many years. So if stock prices jump up and down frequently, it stands to reason that the market’s best guesses for corporate values aren’t that good. Our conclusion, based on market history, is that stock prices are clearly not highly efficient. Accordingly, we’re convinced there’s a better approach than passive/index investing.
Cycles for commodity prices are relatively well understood: When commodity prices are “about right,” it is not unusual for enterprising suppliers to boost their production, since profits are available at prevailing prices. However, since the demand for many commodities is typically relatively stable compared to supply, higher production/supply usually drives prices lower. Lower prices cause suppliers to cut back on production, thus reducing supply. Lower supply leads to higher prices—and the cycle continues.
Growth-style investors tend to focus on rapidly growing companies, even when that growth sometimes comes at the expense of profitability. Using a point we’ve made before, it’s easy to grow when you sell dollar bills for 95 cents— but it’s hard to stay in business this way. Sometime before the current investment headwinds abate, we expect to see a wide variety of “growth at any cost” companies suffer some hard landings.
There is no safety in following the crowd, since the actions of crowds invariably lead to stock price extremes that ultimately self-correct. For simplicity’s sake, imagine an investment approach that calls for buying all stocks that begin with the letter A and selling short stocks that begin with the letter B. If this “investing” scheme proves to be popular, stocks beginning with A will appreciate while stocks beginning with B will depreciate, in typical self-fulfillment fashion. In a true bubble situation, the popularity of “buy As and sell Bs” could grow rapidly, as initial results seem to confirm the strategy. Ultimately, stock prices for As will be driven way too high, while prices for Bs will become way too low. Then, at some unpredictable-in-advance moment, the bubble will burst, and prices for A stocks will plummet while prices for B stocks will rise. This general bubble pattern has played out many times in the past, and it will very likely play out similarly in the future. That said, it is amazing how short investors’ memories can be during the bubble-inflation process.
…just before September the popular media reminded everyone that “September is the weakest month of the year” for stock returns. While this is technically true—September’s average return over the last 90 years has been somewhat less than for any other month—trying to time investments based on monthly average returns is no way to manage a portfolio. This is because there is considerable variation in a given month’s returns, and because price changes in previous specific months won’t necessarily recur in the future during the same months. For example, there was a steep stock market drop in October of 1987 (mostly for geopolitical reasons), but the next similarly steep drop doesn’t need to happen in some future October. Just as it would be overly simplistic for a football team to always pass on first down and run on second down (even if that seemed to work in the past), focusing on specific months or on any arbitrary strategy is just too simplistic to produce successful investing results. It can be dangerous when simplicity overrides thoughtfulness. Everyone, from football coaches to Army generals to investors, needs to remember that the opposition always adapts.
The yield curve—a graphical depiction of interest rates for various bond maturities—usually inverts (i.e., shorter-term bond yields exceed longer-term yields, the opposite of the norm) when the Federal Reserve consciously pushes shorter-term rates higher in order to slow the economy and thus combat inflation. When the Fed wants to slow the economy, it usually gets its way—sometimes leading to a recession. This time [in 2019], the Fed has been lowering, not raising, short-term rates. It’s just that longer-term rates have declined faster than shorter-term rates, thus inverting the yield curve. In turn, longer-term U.S. rates have fallen in good part because interest rates in other countries have fallen even more. After all, the world is to some degree interconnected economically. The impact of the European Central Bank and the Bank of Japan driving interest rates negative has contributed to interest rates worldwide being as low as they are.
Due to today’s very low interest rates, the traditional advantage of bonds for income has evaporated. … Simply put, the dividend yield on the S&P 500 index is now higher than the interest yield (technically, the yield to maturity) on 10-year U.S. Treasury bonds, even though stocks additionally offer the likelihood of economic growth gains and inflation-induced price gains, while bonds do not. … A typical 10-year U.S. Treasury bond was recently priced to provide a 1.53% annual yield to maturity. Unless such a bond is held in a tax-deferred account, the interest is typically taxable each year at the federal level as ordinary income. Assuming a 24% tax bracket for [a] bond’s owner, the 1.53% becomes about 1.16% annually after tax. U.S. inflation has been running at about 2% per year, so 1.16% after tax becomes a negative 0.84% annually after both tax and inflation. Moreover, even if the bond holder paid no income taxes on bond interest, the after-inflation return would still be negative. So why would anyone buy U.S. bonds?
If the overall stock market and individual stocks are more apt to encounter significant short-term price swings these days, then it pays to be prepared to take advantage of these swings. This sometimes means being willing to carry somewhat larger than normal cash/money fund balances in order to take advantage of price dips that can create extreme bargains.
When more and more investors (and their money managers) concentrate their purchases on the most popular companies…— as is the case nowadays—their transactions are commonly referred to as “crowded trades.” With many investors crowded into a relatively few stocks, the result is typically very high stock prices relative to earnings or some other relevant metric. However, while currently high stock prices often reflect good stock performance in the past, they suggest not-so good performance in the future. Conversely, low prices today are frequently associated with above-average returns in the future.
There is a well-documented tendency for investors to have unrealistically high future growth expectations for popular companies and unrealistically low expectations for currently out-of-favor companies. Thus, since expectations are baked into stock prices, more often than not we find rapidly growing companies to be overvalued and slowly growing companies to be undervalued. This is the essence of value investing—to exploit prices that are generally too high due to over-popularity or too low due to under-popularity… In addition, our economic system is very good at encouraging competition for currently successful companies and discouraging competition where the outlook doesn’t seem so good. The effect of growing or declining competitive forces is to slow future corporate growth for today’s rapidly-growing companies and to help future corporate growth for today’s slower-growing companies. In short, the stocks of today’s faster-growing companies typically have two strikes against them: Their stock prices tend to be bid up too high on the basis of over-zealous expectations, and fast growth leads to more competition, which inhibits fast growth. Similarly, today’s unpopular stocks are aided by excessively low expectations and by a reduction in future competition.
If long-term economic growth and stock investment gains are so common, why are so many people fearful of investing in stocks? In a nutshell, the answer is “loss aversion,” which means that many people react more negatively to an investment decline than they react positively to a comparable gain…That’s loss aversion, and it is alive and well within the minds (and stomachs) of most individuals.
If high future stock market returns seemed to be as smooth and predictable as bank deposits, the demand for stock investments would be so high that stock prices would rise to a much higher level. That higher starting level would result in going-forward annual returns that would approximate the low interest rates banks now pay. Catch-22. The perception of smooth and high stock market returns in the future would create the conditions for low future returns. Based on history, over the long term we can pursue high average returns if and only if we are willing to accept near-term price swings—volatility. Put slightly differently, investors are “paid” stock-like returns in order to shoulder the natural volatility of stock prices. No volatility, no high returns. That’s one important reason why volatility is good for us.
Although stock returns and inflation have both fluctuated considerably over time, the year-to-year differences in stock returns— volatility—have been larger. This volatility/bumpy ride sometimes leads investors to conclude that investing in stocks for the long term is risky, but—as with air travel—the risk is more one of perception than reality. If you want to invest for 2,000 days, the outlook for good returns in stocks is relatively high (i.e., risk is comparatively low), even while day-to-day and month-to-month volatility may be high. In a nutshell, risk and volatility are simply not the same thing.
At the end of the day, hardly any investors delve into anything beyond what amounts to pretty cursory research—although they may have thought they were thinking in depth. The most common approach to investing in stocks, bonds, real estate or mutual funds is this: If an investment has done well in the past, it will probably do well in the future. This is essentially momentum investing. It may work well. At least until it doesn’t. And when it doesn’t, things can get ugly fast. Stocks, for example, don’t perform well simply because they performed well in the past. Rather, they perform well because their companies’ technology, operations or marketing perform well. Importantly, … American capitalism is so competitive and dynamic that it’s a very rare company that can produce leading results over the long term. We feel it is much better to carefully evaluate companies’ ever-changing competitive positions than to consciously or subconsciously extrapolate prior results.
Using data from First Trust that dates back to 1926, the average bear market has been about 1.3 years long, which is short in comparison to bull markets, which average about 6.5 years. Succinctly put, bear markets tend to be short and scary, while bull markets tend to be much longer and less steeply sloped. Panicky investors who consciously or subconsciously extrapolate the steep declines in bear markets (“we’re going to hit zero in a matter of months”) can be their own worst enemies. On the other hand, in bull markets investors need patience not to sell too quickly.
For investors with long-term objectives, we find it hard to construe short-term portfolio fluctuations as a meaningful risk within a long-term trajectory of stock-like average returns, unless one of these fluctuations causes an investor to abandon good, long-term investments in a temporary period of weak stock prices. Abandonment of a sound long-term investment program can make temporary declines permanent.
… risk is simply the possibility of not achieving one’s investment objectives. A worker can invest a meaningful amount of money consistently over 40 years and still not have accumulated a suitable nest egg at retirement if that money is invested in T-Bills or money market instruments. That’s risky behavior, given today’s average longevity and typical retirement objectives, even though month-to-month portfolio fluctuations are apt to be very minor. It’s risky because T-Bill returns are unlikely to meaningfully outdistance inflation over the long term—even before taxes. The expression “no risk—no return” is better put “no volatility—no return.” Think of it this way: Investment returns are compensation for investors’ willingness to accept near-term volatility and uncertainty. Going back to the determinants of economic growth, investors need to own (have equity in) something that produces economic growth in order to realize the benefits of economic growth. T-Bills and money market instruments (including bank deposits) are merely short-term loans to borrowers, the largest of which is the U.S. government.
Given the lumpy nature of major innovations, it should be no surprise that the economic growth that derives from innovation would be similarly lumpy. Put differently, don’t expect consistent 10% annual returns. Indeed, don’t even expect consistent five-year or ten-year investment returns. Moreover, while investment returns are driven in good part by economic growth, these returns can run better or worse than underlying economic growth over various periods of time. Ultimately, however, economic growth and investment returns march to the beat of the same drummer.
Realistically, there is no simple formula that leads to success in virtually any competitive endeavor. For example, if a football team employed a (1) run on first down, (2) throw a long pass on second down, and (3) throw a short pass on third down strategy/formula, it wouldn’t be long before defensive teams would prepare themselves accordingly. A successful offense consists of evaluating information and making good decisions based on all factors and conditions. It is no different in investing.
At any given time, the outlook for stock prices over the coming months is seldom clear, because relatively predict-able, long-term economic trends will likely be overwhelmed by comparatively large (and temporary) swings in investor sentiment. Somewhat similarly, the temperature forecast two weeks from now is rather uncertain, as the gradual movement toward spring and summer can easily be overwhelmed by short-term weather patterns. We think stock prices over the next three to five years can be estimated reasonably, just as we think temperatures over the next three to five months are likely to be within a given, warmer range. As these time frames imply, stock market cycles are much longer and less predictable than seasonal changes in the weather. Nevertheless, the interplay between long-term trends and unpredictable, short-term fluctuations is similar.
Historically, sharp stock market declines closely followed by sharp gains are typical near significant market lows. Sharp declines are frequently accompanied by convenient, seemingly-rational justifications—and they are often exaggerated by an accelerant or two.
When investors try to take advantage of investment bargains, there’s always a chance they’ll make mistakes such as mechanically equating low prices with bargains. There is much more involved in bargain hunting. Ultimately, investors need an ability to estimate the intrinsic value of a potential investment. For example, if your neighbor offers to sell you a dollar bill for $1.50, that’s not a bargain—even if he offered the same dollar bill to you yesterday for $2.00. In the final analysis, in order to take advantage of stock market volatility, it is important that investors be able to reasonably estimate the value of potential investments.
There is no doubt that stock market volatility—sometimes significant volatility—will occur from time to time. The important question is, what are we going to do about it? Are we going to follow the crowd by selling when prices drop? Are we going to tough it out? Are we going to try to take advantage of stock price volatility? Before you answer, consider this: There has never been a permanent decline in the U.S. stock market. Moreover, every temporary decline has ultimately been reversed, on the way to new highs. These two historical facts would seem to argue for maintaining one’s investments during market declines or actively trying to take advantage of declines, allowing for your investment time horizon. Simply put, if your investment objectives address a period of years, not months, history is on the side of maintaining or increasing diversified, long-term stock investments.
If economic reality doesn’t change as fast as stock prices do, what causes stock prices to be so volatile? Changes in investor sentiment, which have no physical limits or boundaries, are responsible for most monthly volatility. Simply put, it is human nature to experience worries and elation, and these emotions sometimes change quickly. Moreover, it is also human nature to feel peer pressure.
… investor pessimism is not a predictive factor. It tells us much more about the present than the future. (In economics-speak, pessimism is a “coincident” indicator, not a “leading” one.) Indeed, extreme pessimism is arguably inversely correlated with future stock market returns. [And] it’s not just individual investors who tend to be optimistic near stock market highs and pessimistic near the lows. Wall Street has its own emotional problems. According to a report by Barron’s, in 2018 the least popular 100 of the S&P 500 companies (based on Wall Street analysts’ recommendations) significantly outperformed the 100 most popular companies.
Within the long-term context of a rising stock market, the lowest lows tend to occur during times of greatest pessimism, and the highest highs occur during times of greatest optimism. Accordingly, we should welcome pessimistic times for the opportunities they present.
… stock prices from year to year (the short term) are not determined mainly by long-term economic factors. At any given moment, the price of any stock is determined by the balance of investor sentiment—which is more a product of psychology than economics.
One year ago, Bitcoin and other speculations tied to “blockchain” techniques were all the rage. That was then, of course. Today, Bitcoin prices have plummeted—from over $20,000 last December to less than $5,000 last month. …Frankly, virtually any serious student of markets should have seen the unmistakable signs of a bubble. Bubbles have to end, of course, but the exact timing cannot be determined by rational analysis—because the investment “justifications” aren’t rational in the first place. There will always be bubbles, and they will seem to make sense to many investors at the time, but the laws of economics will not be repealed. High—and accelerating—popularity, whether it be for a particular stock, category of stocks, or style of investing (indexing comes to mind) simply cannot be sustained indefinitely.
… today’s yield curve is relatively flat—the result of the Fed having increased shorter-term interest rates since late 2015. If the Fed continues on a course of higher rates, the current yield curve may invert, and that would usually signal an economic slowdown, though not necessarily anything out of the ordinary. There have been many economic slowdowns and 11 outright recessions in my lifetime. Sometimes the best investment bargains present themselves six months or so ahead of recessions, since stock prices usually move before the overall economy. Given this relationship between stock prices and the economy, trying to time investment purchases via economic forecasting usually proves to be fruitless— since forecasting a dynamic economy more than a quarter or two in advance is very difficult.
Inflation might be thought of as an unlegislated tax on consumers that reduces their purchasing power. One example would be when the electorate demands goods or services from government, like medical care, subsidies, infrastructure, pensions, etc., without adequately paying for these goods or services with taxes. Inflation then results as spending is pursued via monetary expansion (figuratively, money printing)—as opposed to increases in productivity.
Perhaps we’re biased, but we think the amount of economics education in the U. S. is a disgrace. As Thomas Jefferson said, “If a nation expects to be ignorant and free, in a state of civilization, it expects what never was and never will be.” Our nation will enjoy better economic policies once the electorate is better informed about economic realities.
… sometimes with the slightest provocation, investors try to jump ahead of whatever they think others will do. Moreover, with computers helping to speed investors’ reactions, overreactions and reactions to other investors’ reactions, it’s possible to see rather sharp daily moves.
If there’s a trade war (where countries erect barriers to imports, trying to help domestic producers), it would be a negative for the U.S. and probably a bigger negative for countries such as China, Japan and much of Europe. For countries— as opposed to specific interest groups—trade wars ultimately hurt economic growth. For this reason, trade wars are rare and typically brief. It is theoretically possible for a limited trade war to help break down barriers to truly free trade. Importantly, free trade needs to be practiced by all parties if its full benefits are going to be realized.
Just because we’ve identified a bargain-priced stock doesn’t guarantee that the stock price will begin to move upward the day after we buy it—or the month after or the year after. During the time that an undervalued stock temporarily becomes more undervalued, there will typically be near-constant pessimism expressed among investors. Indeed, in many cases the pessimism, reflecting concerns of the moment, will seem to be well grounded. The same goes for overvalued stocks, which a value-oriented investor will sell when their prices significantly exceed intrinsic values. It is not uncommon for such overvalued stocks to be beneficiaries of a type of momentum, fed by near euphoria that drives prices even higher. It is the emotional difficulty involved in buying low and selling high that makes success so hard to achieve.
If long-term corporate performance ultimately drives stock prices […], yet much of share ownership is in the hands of [index] funds that don’t even attempt to think about revenues, earnings, etc., what is there to ensure that the stocks purchased by passive investors are reasonably priced? Some passive/indexing proponents claim that the buying and selling done by non-indexers is sufficient to move stock prices to reasonable levels. Put differently, non-indexers (“active” investors) ensure fair stock prices through their research and investing, and then indexers essentially free-ride on their efforts. If you appreciate irony, the following should be delicious: In short, passive investors say they depend of the “efficiency” of markets—driven and created by active investors—to establish fair and appropriate stock prices for passive investors to accept. Yet these active investors are the very ones that passive investors often characterize as inept!
In the first quarter of 2018, 78% [of companies] beat the consensus [of analysts’ expectations]. If that sounds implausible, consider this: Company CEOs like their stock prices to rise after their financial results are reported— it helps validate the CEO’s management. Accordingly, CEOs frequently “guide” analysts’ expectations lower than they expect to achieve. (Analysts depend on access to CEOs, so they are often happy to go along with the game of under-promising.) When actual financial results come out ahead of such “expectations,” only the uninformed are truly surprised. This can set up a seeming paradox: For example, Acme Widget reports earnings growth of 6%, beating the analysts’ consensus estimate of 5%—yet the stock drops. The explanation is that even Mr. Market is wise enough to know that 5% was an artificially low estimate. Unspoken, but more realistic, estimates might have been closer to 10% earnings growth, so 6% was actually a disappointment, not a happy surprise.
… those investors who have succeeded the most over the long run (Warren Buffett, Peter Lynch, etc.) have typically practiced the same investment style in good times and bad. A good “value” investor, like Buffett or Lynch, sticks to his or her style whether indexing’s popularity waxes or wanes. A good “growth” investor also remains committed to his or her style. These two investment approaches will likely prosper at different times, but what counts the most in achieving long-run success is … well, the long run. Simply put, successful investors are good at what they do, and they practice discipline.
…in recent years the top five stocks have accounted for a growing proportion of the Russell 1000. Indeed, the only time they accounted for even more was in early 2000—just before the internet and high-tech bubble burst—when indexing was riding a wave of popularity. Think of it this way: The top five companies account for 0.5% of the Russell 1000 by number and currently over 13% by weight. That’s concentration. We don’t know when the popularity of the top five will peak, but from historical experience we expect it will.
During the 2010 – 15 period “growth” stocks typically traded at P/Es that were about 7.5 points higher than “value” stocks. We think that’s probably too much, because it’s difficult to sustain higher growth indefinitely. Ask General Electric, Cisco Systems, Digital Equipment and many other former favorites. Nevertheless, we find it interesting that the difference between growth and value P/Es has itself grown from about 7.5 points to over 13 points today. Either growth stocks are now “growthier” than they were a few years ago, or we’re in some sort of growth stock bubble today. Simply put, we don’t buy the “growthier” explanation.
Basically, the concept of market efficiency depends on the notion of very calm, highly-informed and rational human decision making that seems at odds with investment history.
Due to documented investor biases and behaviors commonly known as confirmation bias and recency bias, among others, there is a real tendency for investors to overvalue currently popular companies and undervalue currently unpopular ones. Let’s be clear here: There may well be good reasons for companies to be popular or unpopular, and justifiably popular companies should be valued more highly than justifiably unpopular ones. However, there’s an important difference between “highly valued” and “overvalued.” Popular and unpopular companies tend to become temporarily overvalued and undervalued, respectively, and these temporary tendencies are exploitable in our quest for investment return.
… it’s hard to outrun operational expectations for long. If stock prices outrun already increased expectations time and again, we’re likely in the realm of “momentum,” the catch-all explanation for irrationally high or low stock prices that become even more irrational.
…saving for decades doesn’t get you much at 3%. Why save for 35 – 40 years or more only to exhaust your savings in, at best, only several years? Safety from short-term volatility typically represents no safety from outliving your nest egg.
We think a lack of patience has cost investors more money than any other investing mistake. Unfortunately, the way human nature seems to be, self-defeating impatience is likely to continue. If only we can muster the strength to be patient when it is called for, we can take advantage of the mistakes of others.
…don’t be afraid to buy when the news is bad. Indeed, scary news known to the investing public is most often already reflected in stock prices. In fact, based on history, chances are that most bad news is overly reflected in stock prices. Put differently, if you want to buy low and sell high, the first thing you have to do is buy low—and low prices are often produced by bad news. We can’t overemphasize that investors who wait to buy until the news turns positive almost invariably end up buying much higher, perhaps to the point of buying overvalued investments.
If federal budget deficits are not gradually reduced, there are two main risks: First, with interest owed on the national debt (as a percent of the federal budget) growing, spending on other important categories (like defense, Medicare, infrastructure, etc.) would necessarily need to account for less of the federal budget. Second, a sufficiently high national debt that becomes “monetized” (paid for by essentially printing money) would be inflationary
One year is too short a period for stock prices to closely track earnings growth, but as time wears on, history tells us the closest approximation to stock price growth will be earnings growth. If you think about it, this makes perfect sense. If you own a business over a period of years and the business increases its earnings by X%, it would be reasonable to expect the value of your business to increase by something close to X%. However, this has not necessarily been the case for stock investors over the last 12 months and sometimes longer. The stocks of some companies—mostly large-capitalization “growth” companies—have appreciated significantly more than earnings have grown. … Based on a clear reading of history and common sense, we don’t think stock price growth can significantly trail earnings growth indefinitely, especially with a starting point of relatively low P/Es. On one hand, it is frustrating to correctly estimate earnings growth without seeing commensurate stock price growth. …On the other hand, if the future is at all like the last 100+ years of stock market behavior, stock prices will track earnings closer than any other variable.
Suppose you saw a headline that read, “Retail sales plummet!” Should you sell your retailer stocks? Without further information, the headline— even if true—could be misleading. For example, retail sales plummet every January after strong Christmas season sales. Home sales, energy consumption and many other economic statistics are very seasonal, so simple month-to-month comparisons are fraught with risk for investors who are prone to act on the latest headlines. Consider this one: “Amazon revenues climb 20% from prior year.” Is that good or not? The answer depends on other important factors, such as whether Amazon’s earnings rose commensurately and whether investor expectations were previously set for 25% or higher gains. Flashy headlines sometimes capture the reader’s attention, but relying on them for investment decisions can be dangerous.
If strength in stocks rotates from one sector to another over time, why can’t we invest in sector X while it’s strong, sector Y when it’s strong and so forth? The answer is that sector strength changes unpredictably, and concentrating in a given sector when that sector is already overpriced is risky. When sanity breaks out, we don’t want to be in overpriced investments poised for a tumble. The best that investors can do (in all types of markets) is to take advantage of bargain prices and practice patience. Based on history, this approach is more apt to work to our advantage than trying to jump from sector to sector in pursuit of sometimes fleeting—and always unpredictable—changes in investor sentiment.
In every case where one type of investment has risen dramatically relative to other investments, there has been a temporarily believable story to support the mania. However, “believable” doesn’t necessarily equate to “accurate.” Virtually every high-growth company, for example, has ultimately suffered from some combination of commoditization, market saturation or competition.
Suppose, for example, that larger companies were growing 5% per year faster than smaller companies. That difference is much higher than reality (indeed, smaller companies have historically grown faster, as they start from a smaller base); however, we’ll use 5% to make a point. Under this 5% assumption, it would be logical to think large-cap stocks would provide about 5% higher annual performance, other things equal. So what justifies 85% higher returns? In two words, nothing smart. Primarily, it’s nothing other than investors piling onto whatever has “worked” recently—similar to the way investors/ speculators piled onto the low-volatility mania while it lasted.
…according to [a recent study] there has never been a 20 or 30-year period in which stock returns were negative. This includes the 20 and 30-year periods starting in 1929, just before the Great Depression. So stocks are good at capitalizing on the long-term growth of the American economy.
While Microsoft’s outlook was described as very promising when its stock price was soaring [in the 1990s], its outlook was described in much more pessimistic terms when its stock price was lagging. It’s always been this way. Press reports and news “analysis” are, at best, coincident indicators of stock prices. They tell us almost nothing about the future.
Sometimes people refer to “the stock market” as a single thing. “Stocks” are often characterized as being high or low, for example. However, it is not at all unusual for one group of stocks to become expensive while another group becomes cheap. For example, in 1999 the growth-stock-laden S&P 500 returned 21.04%, while the Russell 1000 Value Index returned only 7.35%. That’s quite a difference, somewhat reminiscent of 2017. However, one year later (in 2000), the S&P 500 fell 9.10%, while the Russell 1000 Value Index gained 7.01%. That’s another large difference, though in the opposite direction. … The irregular cycles of popularity for growth vs. value investments have been with us for decades, and this is just one example of different markets for different types of stocks within the overall stock market.
It may seem comforting to invest in an index with 100 or 500 component companies. However, appearances can be deceiving. For example, the S&P 500 contains 500 companies, so the top 50 companies and the bottom 50 each represent 10% of the index’s total companies. However, the top 50 account for approximately 49% of the index’s weight, and the bottom 50 account for only about 1%. As a result, the effective diversification within the S&P 500 is much less than some might imagine. Similarly, the Nasdaq 100 index is heavily weighted in just a handful of companies. The top five amount to roughly 40% of the index’s total weight. As a result, in any given day, week, month or year it is not inconceivable for this index to move the opposite way from the majority of its component companies.
Clients who have been reading our letters can probably recite most of the key ingredients for an intelligent and successful approach to investing: (1) Start investing as early as possible; (2) stick to it through thick and thin; (3) match your choice of investments to your time horizon, need for inflation-adjusted returns, and tolerance for risk and volatility; (4) diversify, but don’t di-worse-ify; (5) think independently, and don’t be afraid to buck the crowd. These are essentially the five commandments of investing…
Japanese stock prices in 1989 reflected the expectation of very high economic growth almost indefinitely. Put differently, Japanese stock price/earnings ratios in the 1989 era were very, very high (well over 100). The only U.S. parallels I can think of in the last 60 years are the high-tech bubble (circa 1998 – 1999) and a narrower list of extremely popular stocks in today’s stock market. Stocks with such high valuations frequently disappoint investors sooner or later, since trees don’t grow to the sky. In more economic terms, intense worldwide competition usually dents the outlook for previous favorites, and new or recommitted companies frequently become successful by exploiting the weaknesses of the last generation of winners. Yesterday’s predators become today’s prey.
With presumably intelligent investors, how do major bubbles inflate within advanced economies? The answer is grounded more in behavioral economics than traditional economics. For example, suppose we asked a group of individuals which decade contained most of the U.S. Great Depression. (The answer is the 1930s.) Suppose further that 90% of people know the correct answer. Now consider various groups of 10 people, where nine of them intentionally give an incorrect answer, the 1920s. What percent of the true test subjects (the one in ten who isn’t faking an answer) do you suppose will identify the 1930s as the correct answer? We’ll give you a hint: It’s probably significantly less than 90%. Why’s that? Call it peer pressure or a presumption that the crowd is normally right. Frequently the crowd is right, but not always, and the exceptions can ruin an investor’s results. From time to time in markets, the combined influences of peer pressure, a mostly uninformed press, the desire for gain and certainty, and perhaps just plain envy produce some pretty unintelligent, uninformed and, frankly, irrational consensus views. It has happened before and will likely happen again. Spotting irrational stock prices is hard to do in real time, since there are usually so many accepted explanations (many of which begin with the word “new”). Moreover, spotting the absolute peaks of bubbles is just about impossible. The peaks are products of non-analytical thought, so rational analysis may not do us much good. As Warren Buffett has said, “Nothing sedates rationality like large doses of effortless money.”
Since the long-term performance of stocks—which are simply shares of company ownership—will necessarily be determined by each company’s operational results (earnings, cash flow, dividends, asset values, etc.), our focus on long-term operational performance makes sense. Over the shorter term, however, stock prices can and do respond to a wide variety of temporary factors—giving rise to more stock price volatility than operational performance would seem to call for. We like this! That’s because temporarily underpriced or overpriced investments provide us the opportunity to increase or decrease our investments accordingly and thereby pursue above-average returns.
…the fundamental issue of company over-popularity remains. Corporate success breeds additional (and frequently innovative) competition. Competition is great for consumers, but not for established companies. Capitalism virtually ensures a steady stream of new competitors striving for success and dethroning older companies in a process sometimes called “creative destruction.” That’s what happened to Burroughs, Digital Equipment, Kodak, Polaroid, Sears and Xerox, among many others. You can bet it will continue in the future, and some of today’s investment darlings will eventually become answers to trivia questions.
… we remind investors that computers do not think. They simply (and quickly) run programs that are the products of human programmers. When unforeseen events occur, which clearly happens from time to time, relying on computer trading can hasten bad investment decisions.
Everybody loves a winner, as they say, and in investing this equates to investors frequently paying excessive prices for popular stocks. The corollary is that everybody dislikes a loser, so investors frequently drive the prices of unpopular stocks excessively low. Value investing exploits these two tendencies—which are grounded in human nature and studied by behavioral scientists—by focusing on buying unjustly unpopular stocks and selling unjustly popular ones. This seems to be very hard for the average investor to do, including some experts on behavioral finance.
…some investors seem to liken a stock to a race horse—if it has done well in the past, then it will likely do well in the future. Similarly, when stock prices fall—likely raising future returns from their lower starting points—many investors apply race horse reasoning and shun good bargains. Simply put, left to their own devices, average investors tend to buy higher and sell lower … This process isn’t just some theory about investor behavior. It is one of the most fundamental aspects of investment reality. To help get a handle on the impact of such behavior, mutual fund ratings firm Morningstar has coined a term—“investor return.” This is not the average return earned by a mutual fund over time, but rather the average return earned by investors in that fund.
… if a P/E multiple of 15 is about right to reflect the future expected growth of an average company, a better-than-average company might appropriately sell for a P/E of 20, 25 or even 30. (Since it is hard for any company to sustain very high operational growth indefinitely—due to the highly competitive nature of business in a market economy—it is risky to assume high growth for prolonged periods of time.) Let’s assume that Acme Widget Company’s faster corporate growth justifies a P/E of 25. If that’s the case, then Acme Widget’s stock price would be very pricey at a P/E of 50, despite its faster-than-normal operational growth. Good company, bad stock.
When you buy an index mutual fund, you will own a slice of a diversified portfolio that likely includes some struggling companies. Even companies that seem only a step away from insolvency will necessarily be included in your fund’s portfolio, as long as they are in the index being replicated. In short, index investing is the opposite of discriminating investing.
…sometimes the performance of the S&P 500—heavily influenced by its weighting of a relatively small number of very large-capitalization stocks—can significantly diverge from the performance of most stocks. Indeed, this happened with a vengeance back in the late 1990s, an era of significant bubbles in some stock prices.
If you own a variety of mutual funds, as some investors do, the combination of all the funds’ portfolios will likely be spread over so many investments that it becomes nearly impossible to outperform the overall market, given any level of fund expenses.
… although we think value/ GARP investing is well positioned for relative success in the coming months and years, nobody can be certain of the timing. There will likely be times when bubbles continue to inflate. What we can say is: (1) there are no instances of aggregate stock prices advancing faster or slower than underlying corporate earnings indefinitely; (2) stock market history is filled with instances of unjustified over-popularity or under-popularity of given companies, and eventually over-valuations and under-valuations correct; and (3) following the crowd is seldom, if ever, a successful long-term investment strategy. The key to investment success is leading the crowd. Leading requires diligent research, a patient temperament and a tolerance for being temporarily out of step with conventional wisdom.
Since investors sometimes overreach for corporate growth, the stocks of faster growing companies may become dangerously expensive (a bubble). Correspondingly, sometimes the stock prices of average-rate-of-growth companies may not even keep pace with their own corporate earnings, as the money used to buy growth company stocks is usually raised by selling the stocks of these more typical companies—pushing their P/Es lower and making their stock prices increasingly attractive (an inverse bubble). Sooner or later, the environment of bubbles and inverse bubbles comes to an end. Perhaps the fastest growing companies slow down, either due to competition or simply due to the law of large numbers (it becomes increasingly difficult for larger companies to sustain high growth). Or perhaps overall economic growth improves, helping average companies more than growth companies, which are sometimes thought to grow independent of overall economic growth. Or perhaps someone notes that some growth-stock emperors aren’t wearing any clothes. (The current P/E for Amazon is over 150.)
Stock investors who want old-fashioned 10% average annual returns would seem to need to invest differently than just owning stocks in general. One approach might be to concentrate in companies that seem poised to grow faster than average. Companies like Apple, Amazon, Facebook and Google, for example. If only a small number of investors followed this approach, it might work. However, when enough investors pursue growth investing, their buying ultimately pushes growth stock prices higher than would be attributable solely to corporate earnings growth.
Since the multi-year future outlook for the combination of stocks in a typical portfolio or index is unlikely to change much from day to day or even month to month, portfolio or index prices seemingly shouldn’t be very volatile. The fact that they are characterized by volatility tells us that factors other than multi-year future outlooks for companies are at work on a regular basis. Among these other factors are short-term swings in investor sentiment and momentum-based “investing” by individual and professional investors. We welcome such influences on stock prices, as they help drive prices too high or too low, compared to analysis based on operational and economic factors.
The prime reasons why value investors have done better over long periods of time are: (1) the intensely competitive environment among companies makes it hard to sustain high corporate growth for the time required to justify very high stock valuations; and (2) investors have a well-documented tendency to overvalue popular, faster-growing companies and undervalue unpopular, slower-growing companies. Investors, amateur and professional alike, sometimes find it emotionally difficult to own unpopular companies—the ones that are more likely to sell at bargain prices—or to refrain from owning glamorous, story stocks (Tesla, for example) that can sell at high price/earnings ratios. Ultimately, value investors take advantage of other investors’ behavioral biases.
Indeed, we’ve purchased some of our best investments during times in which value stocks underperformed—and these investments not only helped us ultimately offset any temporary underperformance, they also contributed to our overall outperformance over the longer term. Simply put, we have no control over short-term trends in investor sentiment. All we can do is react to undervaluations and overvaluations by buying and selling accordingly, taking advantage of the situations that present themselves. If we can do this well enough, our future will be bright, notwithstanding what happens in any given quarter (or year). Indeed, if value stocks did not fall from favor every now and then—producing juicy opportunities for long-term investors—we doubt our track record would be as good as it is.
Over long periods of time, value stocks have outperformed growth stocks. Though that might seem counterintuitive to some, the reality is that although growth companies tend to grow faster than value companies, investors tend to overpay for growth—making it hard for growth stocks to outperform. Simply put, their starting prices are frequently just too high to allow for good future returns.
…we would suggest that investors stop thinking of robo-advisers as computers that have “solved” investing and start thinking of them as the manifestations of their human programmers. Simply put, robotic advisers/investors are no better or worse than their programmers, and there are meaningful differences among programmers. Importantly, while human advisers are more capable of adapting to new situations (perhaps like a Trump presidency), robo-advisers must rely more on prior programming, which is necessarily a simplification of thorough human analysis.
…as the prices of index stocks grow comparatively higher (and higher) relative to non-index stocks, they also grow increasingly expensive in an economic sense. Ultimately, Humpty Dumpty falls and index investors and others who own index stocks suffer. This is bad for index investors, but good for value-oriented investors.
Successful investing is not so much a case of 160 IQ investors outperforming 140 IQ investors, but rather the result of going the extra mile of disciplined work. In addition, an appropriate and patient temperament is not only helpful, but essential. So are intellectual honesty, emotional control and an appreciation of crowd psychology (now commonly referred to as behavioral psychology).
…over the years many people have sold out of fear, only to end up hurting their own portfolios, because (1) the overall market advanced significantly while they were on the sidelines, or (2) they lacked the emotional conviction to re-enter the stock market, even when stocks were on sale. It is very difficult to successfully play market swings. Over the longer term, it is all but impossible.
From time to time clients ask whether they should downshift from an equity-based retirement portfolio in their earning years to a predominantly fixed-income portfolio after retirement. Depending on the size of one’s nest egg at retirement, that may be possible. However, for most 67-year-olds with two decades or more of life expectancy likely, moving from stocks to bonds will typically reduce the amount of time their retirement savings will last.
… for long-term investing before (and in!) retirement, historical results suggest that fixed-income investing is risky—because many investors will not achieve their objectives—and stock investing is appropriate for those who wish to adequately (and intelligently) fund retirement.
…important stock market lows occur coincident with lots of pessimism—and as much as this may seem to make intellectual sense in good times like the present—when the next bear market comes, some investors will slip into what we call “emotional overdrive.” At that point, all of one’s earlier intellectual understanding of markets and investing gets flattened by a runaway freight train of emotions. Successful investing comes not so much from raw intelligence as from a calm, long-term perspective. If you can’t maintain a proper perspective, you might as well put your money in a bank savings account that’s currently yielding less than 1% annually. You’ll do better than chronically selling low (and later buying high).
…it is possible for some investors to outperform all-stock index funds that buy stocks merely on the basis of their weights in certain indexes. Indexed portfolios have no regard for the investment merit of any stock, and if this indexing approach sounds too simplistic to be true, please rest assured that it is the case. Index funds care not a whit about the outlook for specific companies and their stocks. Interestingly, from our observation the average long-term investor’s portfolio (if he or she is advised by the typical stockbroker or “investment consultant”) includes numerous investments from asset classes that are demonstrably inferior to stocks over the long run. We continue to be amazed at the portfolio statements we see from prospective clients, filled with the likes of commodities funds, low-yielding fixed-income investments, and nebulous, frequently expensive “alternative” investments. We would hazard a guess that it is all but impossible for such portfolios to keep up with the average return for stocks over the long run. These “di-worse-ified” portfolios help us to gain new clients, but we wish other investors didn’t have to suffer so much at the hands of this ineffective approach.
...there are at least two good opportunities to profit from change: First, assessing the impact of change isn't always easy, so there are always opportunities to gain from a better research and analysis process. Put differently, experience and skillful analysis help. Second, and perhaps even more important, index investors are always there to help us. When the outlook for a particular company improves due to changes in the economy, we need other investors who are not guided by the company's economic outlook to sell the shares we want to buy. Correspondingly, when we want to sell a company's stock because its outlook has turned less favorable, we need investors not guided by economic sense to buy the shares we want to sell. In a nutshell, those are indexers--since they buy , sell or hold stocks based merely on the makeup of various stock indexes. Especially during times of significant change, index funds have no ability whatsoever to change in response to a changing environment.
Some people advocate high corporate tax rates as an instrument of social policy. Importantly, however, high tax rates can affect companies' competitiveness and capacity to hire more workers. Moreover, some economists make the argument that corporations don't really pay taxes--rather, they simply collect them from consumers, who bear the final burden of virtually all taxation.
…if anything is likely to affect the trend rate of growth of the U.S. stock market over the next decade, it will be productivity growth, which leads inexorably to real economic growth. Since such growth has slowed over the last 15 years or so, this slowdown has not likely been the result of any particular U.S. President or Congress. From our perspective, productivity growth flourishes when innovators, entrepreneurs and motivated workers feel that if they are successful in creating quality goods and services, they will reap appropriate rewards. The existence of a skilled workforce—with skills well suited for today’s economy—is vital for economic growth. Our nation is currently lacking enough skilled workers, and fixing this problem won’t occur overnight. Importantly, there are hard working and skilled people throughout the world, and the U.S. has often attracted many such men and women, including my Italian grandfather, with the promise of opportunity. Personally, I’d rather have such people on my team than have to compete against them. The history of our country—which is the history of the marketplace being used to effectively and efficiently organize producers, consumers, entrepreneurs and workers in ways to promote national growth—is certainly encouraging. However, this story will need time and a supporting environment to flourish as it has in the past. Importantly, no country in history has succeeded in the area of economic growth more impressively than the U.S. As Warren Buffett says, “It has never paid to bet against America.”
Did you know that according to Department of Labor statistics, the number of open manufacturing jobs in the U.S. currently stands at the highest level in 15 years? Manufacturing jobs typically pay well in excess of the minimum wage, yet due to shortages of skilled workers, many of these jobs are remaining unfilled. Less domestic manufacturing means more imported goods and less economic growth. Put somewhat differently, an effective investment in worker skills could really pay off.
The overall stock market has been comparatively calm so far this year, but sooner or later greater upward and downward volatility will return. In all my years as a professional investor, nobody has called to complain about upwardly volatile stock prices…
Every economy needs to make decisions regarding what companies and industries deserve the finite amounts of investment capital available in the economy. For example, should cell phone producers or walkie-talkie producers receive investment capital? Men’s blazers or leisure suits? Widgets or gadgets? In a functioning capitalist economy, investors essentially make these decisions every day as they choose which companies to invest in based on available information. Historically this approach has worked very well to satisfy consumer demands and promote economic growth. In a Marxist economy, central planners (government employees) make the decisions. For example, in the Cold War days, USSR resources were directed toward producing ICBMs more than refrigerators—regardless of what the public wanted. That’s typically not so good in terms of economic efficiency. Lastly, in a supposedly capitalist economy where investment capital decisions are made by indexing (a prime example of passive investing), no consideration is given to any factors other than a company’s existing size (market capitalization). Put differently, in a Marxist economy at least some consideration is given to various factors, whereas in a purely indexed economy, capital allocation decisions are basically static. That’s why indexing is worse than Marxism—even when indexing doesn’t account for fully 100% of investment decisions.
It makes no sense to us that a company’s outlook should depend on whether it is in some index…[When] indexing proceeds to the point that large amounts of money flow to companies in indexes—regardless of their investment merit—we’re going to have problems both in terms of index returns (index companies will become overpriced) and in terms of national economic growth.
It is very important to remember that factors such as economic growth, inflation and dividend yields help determine stock returns for the overall stock market over many years. Specific companies can—and frequently will—experience operational growth that’s far above or far below the level of national economic growth. For example, Costco has grown much faster than most companies for a long while, whereas Sears hasn’t kept up with other companies for decades. Put differently, the above three components of our stock investing “stream” will do a better job of explaining future long-term returns for the S&P 500 than for specific stocks or focused portfolios of, say, two or three dozen companies. Combining and reiterating the points in this discussion, we feel that investors in an S&P 500 index fund, for example, should expect lower than historically-average returns in the coming 10-year period. ( As always, it is not possible to guarantee future returns.) Investors who want to pursue returns closer to historical stock market averages will need to look elsewhere or to be successfully selective in their stock investments.
Successful investing requires intelligent analysis of both short-term and long-term factors. While long-term factors are typically much more important, it’s the short-term ones that dominate news media stories—so don’t hold your breath waiting for headlines regarding long-term productivity trends. Many years ago, before I became a professional investor, I developed a simplistic “stream theory” to help explain some aspects of long-term investing to my students. To illustrate this line of reasoning, picture yourself in a canoe paddling downstream, and suppose that your destination is many miles away. Suppose further that over the course of your canoe trip the average stream velocity is four miles per hour, with faster speeds over steeper stretches of the stream and slower speeds along flatter terrains. In the context of this canoeing example, the average stream velocity is a long-term factor. That is, stream velocity—and your average paddling rate—will largely determine how long your journey will take. On the other hand, the locations and durations of steep and flat terrain amount to short-term factors—sometimes exciting and sometimes not. Anyone who extrapolates these short-term occurrences is likely to risk misjudging the overall journey. As investors, we need to focus on long-term factors—not last month’s or last year’s news—and consciously place ourselves in investment streams that have the requisite average velocity to get us to our financial destinations within our investment time horizons. For example, stock streams typically flow faster than fixed-income streams over the long term. Within the stock category, there are important quantitative factors (like low price/earnings ratios) and qualitative factors (like industry dynamics) that affect stream velocity for specific stocks or groups of stocks.
Few things distract investors more than taxes. For example, would you accept $100 less investment return in order to save $25 in taxes? Believe it or not, some investors would. We wouldn’t, because our after-tax return on that $100 is apt to be much higher than $25. When we sell stocks near all-time high prices, as we have recently, there will likely be capital gains realized. However, we believe that our clients will be better off paying the necessary taxes than they would be by continuing to hold overvalued stocks and not owning more attractively-priced ones. If we didn’t believe this, we wouldn’t sell.
The world today seems increasingly focused on the legislated approach to economic prosperity, and as a result it is suffering from lower growth—relative to much of the post-World War II era—even in leading countries like the U.S., Japan, Germany and the U.K. (There are additional factors, such as aging populations, that are contributing to slower growth.) One can hope for something less than 1,000 years of disappointing growth, but for now the growth outlook is muted. That’s one reason why interest rates are as low as they are throughout much of the world. Indeed, the yield on 10-year U.S. Treasury bonds recently hit an all-time low. Moreover, the yields on 10-year German and Japanese bonds are actually negative. That’s not a misprint. While we can’t predict near-term moves in interest rates, we will make this prediction: Investors’ after-inflation and after-tax returns on most so-called high-quality bonds over the next 10 years are apt to be (1) the lowest in a long time and (2) negative. Investors who use historical bond returns to justify the inclusion of bonds in their long-term, growth-oriented portfolios are deluding themselves.
In the final analysis, it’s economic growth that allows for the increasing fulfillment of people’s myriad wants and needs. However, although the conditions necessary to nourish such growth are relatively easy to describe, they seem to be very hard for human nature to accept.
All colleges have expenses, and these expenses must be borne by someone. Yes, we can make college education free to students and their families, but only by shifting the costs to others. If those bearing the costs amount to society at large, we can say these costs have been “socialized.” If taxpayers primarily are to pay the costs—especially income tax payers—then the costs are shifted more to higher-income earners, since they pay the lion’s share of income taxes. Like most other issues, there are intelligent points to be made in support of and against socializing the costs of college education. If more college entrants led to more graduates and a more skilled workforce, other things equal, economic growth would likely increase. That would be good for our investments across the board. However, other things are seldom equal. For example, tax dollars paid to support college education are not available for taxpayers to use for other purposes, including alternate forms of education. Thus, it is not possible to say without reservation that the benefits of subsidized college education would (or would not) outweigh its costs. We’re not going to take a stand, other than to suggest that the debate on this issue— and similar ones—would probably be more productive if we stopped using the word “free.”
Either the businesses that hire low-skilled laborers can pass the costs of higher minimum wages on to their customers, or they can’t. If they can, then consumers will pay the costs of higher wages. If businesses can’t pass on their costs, they must successfully absorb them (potentially reducing funds for business expansion or other purposes), lay off some employees or go out of business. In all cases, there are costs associated with higher minimum wages, and somebody—whether it is consumers, business owners or laid-off workers—must bear these costs. At the same time, there are benefits of higher wages paid to those workers who retain their jobs. Which outweighs which? The academic literature tends to lean in the direction suggested by the sponsors of the various studies (e.g., businesses or labor unions), so there is no universally accepted conclusion. One thing is certain: If higher minimum wages worked as their strongest proponents suggest, workers throughout the world could be made rich simply through legislating high wages. Here we go again: There is no free lunch. Ultimately, worker productivity determines wages.
Other things equal, high stock prices today spring from good past returns, but are not so good for future returns. Therefore, if the price of an existing investment rises enough—or if the business outlook deteriorates enough—such that the amount of expected return left for the future becomes small, we sell the investment or at least trim our holdings. Similarly, when our expectations for a given company’s stock improve sufficiently, we buy it or add to an existing position. On average, our holding period between purchase and sale is about 4.5 years, but sometimes it is very short, and sometimes it is more than 10 years. We can’t change the realities of the business world. We simply seek to intelligently anticipate and react to them.
Over the years, we’ve written about numerous behavioral biases that work to rob investors of their desired investment success. Here are two interesting (and related) biases, according to behavioral scientists: The first is known as “present bias.” This occurs when investors place a very high value on the limited rewards of today’s purchase of some of the smaller comforts in life—at the expense of the ability to purchase much larger amounts of life’s comforts over time through investing. The second bias is called “exponential-growth bias,” which refers to a lack of understanding/ appreciation of how much compound returns … well, compound over time. Working together, these two biases result in a lot of disappointed people come retirement time. Indeed, a study by the National Bureau of Economic Research (NBER) concluded that these and other behavioral biases have cost Americans about $1.7 trillion. That’s about $5,300 for every man, woman and child in the country. While most investors, by nature, are less susceptible to present bias and exponential-growth bias, many Americans are affected by them. The NBER study concluded that fully 55% of Americans are “present biased” on money matters.
It is a mistake to think it wise to “not touch principal,” because (1) inflation will be “touching” (eroding) your principal anyway, and (2) a preoccupation with yield-oriented investments can lead to under-diversified and sometimes overpriced portfolios. It is better over the long term to focus on the prospects for higher total returns that come from diversified portfolios of attractively-priced investments.
…with the benefit of hindsight, the progression of events may seem to have been obvious in advance. In reality, this is very seldom the case. Amidst the large amount of economic and financial data available, there will almost always be some data that support the case for rare future events, but finding that data and giving it critical importance—overriding all other data—is all but impossible … So for most investors, buying or selling in advance of some anticipated event can be an exercise in futility. Indeed, it can be—and sometimes is—worse than that, because the near-term future tends to be less predictable than many investors realize. Investors who find themselves zigzagging at the slightest provocation often end up with about as much success as a dog chasing its tail.
…the seemingly counter-intuitive moral of this story is that for all practical purposes, the best bear-market strategy is to remain invested in stocks—because the bear market will end at some unpredictable point, and it is very important to take advantage of bear-market opportunities and be invested when the stock market unpredictably shoots upward in recovery.
Especially over a period of several months or less, stock market moves simply don’t tell us much. They can, however, provide us opportunities. Indeed, I recently read an interesting comment about market cycles: ‘Every past bear market is viewed by investors as an opportunity, yet every future bear market is viewed as a risk.’ I don’t know who wrote this, but I think the author hit the nail on the head. With the benefit of hindsight, almost everyone realizes that great opportunities were created in the last bear market.
While long-term stock price movements are reasonably knowable and understandable (prices rise to reflect advances in science, medicine, productivity and inflation), future short-term stock price movements are always unknowable. Always. This economic reality can prove difficult to accept for some investors who are schooled in the sciences. For example, health care workers are trained to treat a bleeding patient by working to stop the bleeding. Since bleeding doesn’t typically stop spontaneously, it makes sense to practice and preach, “Stop the bleeding.” However, financial markets don’t bleed, much as it may feel that way at times. Over the short term, selling a diversified portfolio of investments to stop it from “bleeding” is at least as likely to stop future gains as future losses. Over the long term, selling will do just one thing: It will stop gains.
For the overall stock market, it’s hard to imagine that the economic outlook could change as dramatically from day to day as stock prices fluctuate. That leaves changes in investor sentiment as the most powerful day-to-day force on stock prices.
Importantly, Yogi Berra had it right when he said, “It’s tough to make predictions, especially about the future.” Indeed, historically speaking, investors have shown a pattern of overestimating the future growth of faster-growing companies and underestimating the future growth of value companies. Such overestimating and underestimating logically should lead to the typical growth stock being overly expensive and the typical value stock being overly cheap, which should eventually result in the outperformance of value stocks (assuming you believe, as we do, that the markets ultimately reward actual growth). Indeed, this is what has occurred over the long term.
We are bargain hunters. Indeed, most of our current holdings of growth stocks resulted from buying value stocks that subsequently graduated into the growth category (i.e., became more expensive), given their good earnings growth and investors’ (belated) recognition of this growth. That’s what we always like to find—unrecognized growth stocks masquerading as value stocks. This provides excellent investment results, while the opposite move—from growth to value pricing—is obviously not so good.
For the intelligent investor, there are only two primary questions to address regarding potential investments: (1) What are the risks over my time horizon? and (2) What are the probabilities of various returns over my time horizon? Simplistically, short-term oriented investors should knowingly accept small amounts of after-tax, purchasing-power loss by investing in T-Bills, bank deposits, money funds, etc. in order to preclude unacceptably larger short-term losses. (Yes, we said “loss,” because that’s what you should expect from these sorts of investments, after taxes and inflation.) For long-term investors, diversified portfolios of stocks have provided the best after-tax real returns over time. Based on both historical results and future prospects, we primarily invest in stocks for long-term returns, and we maintain money-fund buffers to accommodate clients’ short-term needs for periodic withdrawals.
Were newspaper headlines during the most intense part of the market correction helpful or harmful for investors? The easiest answer is “yes,” since depending on one’s investing experience and temperament, the headlines could have proved to be either helpful or harmful. Consider these headlines from the most popular financial publication in the country, The Wall Street Journal, during the thick of the stock market correction:
August 21st: Growth Fears Send Stocks Into Skid
August 22nd: Stock Plunge Picks Up Speed
August 24th: Market Rout Upends Winners, Losers
August 25th: Markets Reel in Global Selloff
August 26th: Late Tumble Dashes Hope for Rebound
Headlines like these reflect alarm or even panic. For an inexperienced investor, they can create pressure to sell: “Save yourself before things get worse.” However, successful investors are aware that a whiff of panic almost always accompanies market lows. Therefore, seemingly scary headlines can be a tipoff that good buying opportunities may be close at hand. Reminiscent of the Peanuts cartoon in which each year Lucy yanked the football away from Charlie Brown just as he went to kick it, some investors fall for scary headlines time and time again.
The claim that investors can obtain S&P 500-type returns simply by purchasing an index fund is contradicted by the evidence. Earning index-like returns investing in an index fund may seem to work in theory, but in practice the average investor has not been able to resist the influence of Mr. Market. As a result, achieving index-like returns is a pipe dream for most investors. Better-than-S&P 500 returns demand well-above-average investment temperament, and even basic index-like returns demand better patience and temperament than the average investor has. As Shakespeare commented in Othello, “How poor are they that have not patience.” Judging by investor actions over the intervening 400 years, pretty poor indeed. We’re here to help our clients maintain patience and a winning temperament, and that’s one reason why we write these letters.
…in the past when stocks averaged much lower than 10% returns, subsequent 15-year average returns worked their way back to the 10% level—and then typically moved higher. Similarly, when 15-year average returns were much higher than 10%, subsequent returns were lower. This pattern makes sense: When stocks have underperformed their long-term average for 15 years, they may well be cheap. And when you start with cheap prices, future returns should be higher. Conversely, when stocks have significantly outdistanced the 10% annual threshold over 15 years, stocks as a whole may be expensive, which can lead to lower future returns.
The particular worries behind each stock market decline tend to be different. They might include possible recession, inflation, geopolitics, war, Y2K or something else. However, these “differences” amount to the same thing—there is a temporarily plausible threat to economic stability. In this important regard, all stock market declines are essentially alike. Further, while a resolution of the various obstacles to economic stability may seem unknown or uncertain at a given time, over the years the strength of human ingenuity in overcoming such obstacles has been both remarkable and consistent. It’s not a wise strategy to bet against human progress.
Logically, there will be future periods of strong economic growth and periods of recession. Similarly, XYZ Corp. will likely enjoy both good times and bad. Since these future occurrences are to be expected—and should already be reflected in current stock prices— when temporary good times or bad occur, the current value of XYZ stock shouldn’t necessarily change a lot. However, human nature tends to project expectations that current conditions will last quite a while—even when that’s not normally the case. (Although economic expansions can last for several years or more, recessions are typically quite short: The average recession since the mid-1930s has lasted about 11 months.) If it seems remarkable that some investors who have lived through numerous short-term economic cycles should repeatedly act as if short-term factors will be long lasting, you’re right—it is remarkable. And illogical.
…when it comes to investing, stock market behavior that is described as cyclical is more akin to the irregular short-term variations in the number of sunspots above or below their usual 11-year pattern. While the long-term record of stock prices has clearly been upward, there have been many fluctuations around the long-term trend that were caused by temporary factors. The long-term upward trend has been driven by a growing economy enabled by advances in science, medicine, technology and education, so this trend makes logical sense. Short-term stock price swings above and below the long-term trend are frequently driven by emotional overreactions to transitory occurrences, so these variations are often anything but logical. Many investors have put their understanding of long-term economic growth to work through patient, long-term investing and have achieved remarkable success. On the other hand, other people have tried to understand or predict emotionally-driven short-term market swings, but we know of none who have succeeded with sufficient long-term consistency to rival the results achieved by patient, long-term investors.
The higher Mr. Market’s optimism, the higher [a company’s] near-term stock price, and the lower its future returns. Indeed, if the initial price is sufficiently high, the stock’s future returns could be negative. ... Simply put, over-optimism is a bad thing for future returns. On the other hand, near-term over-pessimism is a good thing for those who can maintain a focus on the long term. Indeed, other factors equal, the greater the near-term pessimism, the lower the stock price in relation to intrinsic value, and the better our future returns.
Competitive investing, like the Tour de France, is a contest in which the winners emerge over the long run. By the way, unlike some previous Tour de France competitors, we have taken no performance-enhancing drugs, unless you consider long hours of research a drug.
Some people have convinced themselves that a lack of knowledge about economics and investing won’t stop them from earning good returns. They believe, for example, that an investment’s risk is best understood not as the adverse possibilities driven by global competition, changing technology, unproductive corporate acquisitions, poor labor relations or any of a long list of other factors. No (they say), risk is best understood as “beta” or some other measure of an investment’s day-to-day price changes. We can illustrate the fallacy of this reasoning in just two sentences: Consider a hypothetical investment that falls in price by the exact percentage decline of the S&P 500 on days the S&P 500 declines, and gains slightly more than the S&P 500 on days the S&P 500 gains. By definition, this investment will have greater volatility than the S&P 500, but there is no reasonable way to regard it as riskier—unless you regard better gains as risky. If you accept the notion that historical volatility (including upward volatility) is itself risky, you are ready to let a simple/simplistic computer program churn out “efficient” portfolios, provided you are ready to ignore history and accept an even shakier assumption—that the mathematical correlation between asset classes (stocks, bonds, etc.) and between individual investments within asset classes is knowable in advance. (By the way, different computer models will invariably spit out different suggested portfolios, reflecting different human programming.) Once you’ve essentially assumed away many of the realistic factors in investing, you can go buy any desired combination of large cap stocks, medium caps, small caps, international stocks, bonds, etc. for your portfolio. Exchange traded funds (ETFs)—typically narrowly-defined “portfolios”—are made for this approach, and their popularity has increased in recent years. However, since historical volatility and asset class correlations change all the time, computer models will frequently call for different allocations—the investing equivalent of a dog chasing its own tail.
History teaches us that there will be bear markets from time to time, but they will very likely prove to be temporary. Indeed, I am looking forward to living through another half-dozen or so bear markets, because: (1) this will likely necessitate me living to a ripe old age, and (2) the greatest bargains—and the greatest opportunities for future growth—come in the depths of bear markets. ... As fascinating as bear markets are, they simply can’t be predicted with any precision. We can’t over-emphasize this point, and you shouldn’t either. Anyone who says he can predict the timing of bear markets is mistaken or, worse, misrepresenting his abilities. There are people who sincerely believe they can time markets, but when it comes to successful investing, sincerity is not enough. Among those who claim—often with much fanfare—they can practice near-exact timing, the chances of encountering misrepresentation climb alarmingly. Simply put, bear markets are an integral part of long-term investing, and they are unavoidable. The history of bull and bear markets combined shows that long-term stock returns have proved to be excellent, especially compared to bonds or commodities. History also tells us that attempts to keep the good (bull markets) and avoid the bad (bear markets) frequently lead to the opposite combination.
Investing typically involves forgoing the use of your money today with the expectation that wise choices (which involve significant long-term return potential, along with some uncertainty and risk) will lead to sufficiently greater after-tax purchasing power in the future to compensate for the wait. In contrast, saving typically involves storing your money safely, with the expectation of preserving your pre-tax dollars, though not necessarily your after-tax purchasing power. Very simply put, investing is primarily about growing your purchasing power, while saving is more about maintaining your dollars (or losing purchasing power at a modest rate).
What causes investors’ portfolios to average annual returns less than 10% over a work career and retirement? There are two primary reasons for such performance: First, some people get frightened during bear markets and sell or reduce their investments when stock prices are low. Second, some people don’t have all-equity portfolios, because they erroneously regard stocks as being too risky for the long term and regard counter-productively diversified (i.e., “di-worse-ified”) portfolios as being safer and more appropriate. Today it would seem generous to regard a broad portfolio of bonds as capable of producing 3% annual returns in the future. So if an investor devoted, say, 60% of his or her portfolio to stocks averaging 10% annual returns and 40% to bonds averaging 3%, the portfolio’s expected return would only be about 7.2%. Simply stated, the more you add investments that aren’t capable of generating approximate 10% annual returns to your portfolio, the more your portfolio’s returns are likely to fall short of that important level—with significant consequences. Put differently, the power of compounding is so great over a combined work career and retirement that small differences in average annual return produce big differences in outcomes.
Myths such as the alleged equivalence of risk and volatility abound in investing, perhaps because it is often to the economic advantage of the perpetrators of such myths. One common myth is that buying an annuity will prove to be a wise choice for retirement income. Here’s our take on retirement income for those who are approaching retirement: Either you have accumulated a nest egg sufficient to provide long-term income with purchasing power protection, or you haven’t. If you haven’t, purchasing an annuity isn’t likely to solve your problem. After all, if you purchase an annuity, you simply give your money to an insurance company, which typically invests it in stocks, bonds (which are likely to underperform stocks over the long term) and real estate—something you could do without having the insurance company’s profit and sometimes steep expenses reduce your return. The insurance company uses your funds (comingled with those of other annuity purchasers) to pay you a monthly income. However, since the insurance company’s after-expense rate of return over the long term is apt to be meaningfully lower than the return achievable in a simple stock index fund, for investors willing to invest in stocks for the long run and living to an average life expectancy, annuities will decrease, not increase, their retirement income plus estate.
…monthly moves in stock prices are essentially meaningless. The long-term trend of U.S. stock returns has been about 10% annually (with considerable year-to-year variation), and despite a multitude of changing economic and political conditions in the past and likely in the future, there is no reason to think future long-term returns will be much different. The reason is that long-term stock returns are driven much more by the relatively steady advancement of science, medicine, innovation and entrepreneurship, and not nearly as much by economic cycles or politics. Yet the daily news is dominated by stories concerning economic cycles and politics rather than innovation and entrepreneurship, so we conclude that you shouldn’t expect to become a successful investor by watching or reading the daily news.
Some of those who argue for including bonds in a diversified portfolio (we might say “di-worse-ified”) would say that bonds reduce risk by reducing volatility. However, we think there’s a big flaw in this reasoning: Simply put, volatility is not risk. Risk is the chance of losing your purchasing power or, more broadly, failing to achieve your investment objectives. If you invest in bonds in order to try to produce after-tax, after-inflation purchasing power over a typical retirement time horizon, it’s going to be very cold comfort knowing that your portfolio was less volatile if it fails to support you in your later retirement years. Similarly, will a stock portfolio necessarily reduce you to a quivering mass of fear if it temporarily declines in value from time to time en route to increasing your purchasing power through long-term, stock-like returns? So we repeat: Volatility is simply not the same as risk. The sooner investors accept this piece of common sense, the sooner they can start to think about realistic investment choices. Stocks are appropriate for investors with a long-term time horizon (which may include investing for one’s heirs) and with investment objectives of growth and income. Shorter-term, high-quality bonds are appropriate for investors who are willing to sacrifice significant returns in order to achieve less short-term volatility. Long-term and “high-yield” (think Greek, Russian and other junk-quality) bonds are appropriate for speculation.
Investment strategies that may have been appropriate for short retirement life spans have become ridiculous in today’s environment. Nowadays, most 65-year-old investors need to prepare for multi-decade retirements, which means (given inflation) they need to focus not only on their income, but also on the growth of their income. By the way, these life expectancies are based on representative samples of people in the U.S., including some with limited access to health care, risky lifestyles and other real-world problems. If you have better access to health care, a healthier lifestyle, etc., you might want to regard these projections as conservative.
The price system isn’t a form of economic magic. It works because it influences very large numbers of consumers and producers to make changes that are in their own interests.
As with oil, prices in the markets for all other commodities, products, services and investments are prone to over-react in the short term, as it takes a while for the necessary changes to occur. Rather than becoming frightened by very low prices or over-exuberant due to very high prices, successful investors concentrate on powerful longer-term trends and take advantage of short-term price volatility. After all, it’s only in seemingly-scary times that other investors will sell us their investments at ridiculously low prices, and it’s only in overly-optimistic times that they’ll buy our investments at very high prices.
Many investors need to feel good about the outlook for their investments before they buy, but stocks almost always make their lows during very gloomy times (as in 2009). So it’s extremely difficult to feel good enough to buy low, yet buying low is step one in timing the markets. Catch-22. It isn’t hard to find financial advisers who nod their heads and say they don’t attempt to time markets, but their ever-changing “asset allocations” essentially amount to just that. Put differently, some of the same people who claim that market timing of individual investments is impossible seem to think that timing via changing the weights of various groups of investments (e.g., large-cap growth, small-cap value or other categories) will somehow work. This is akin to saying that if you group unpredictable individual things, somehow the group becomes predictable. We know of no advisers or market gurus who have successfully timed individual stocks, mutual funds, exchange-traded funds, or asset classes on a consistent basis. Indeed, studies of market timing, fund switching and asset-class changing suggest just the opposite.
…some investors have built portfolios that would hold up relatively well if the circumstances of the 2007–09 recession recurred. However, if there is another financial crisis in the future, we suspect it will be very different. Whereas banks and other financial institutions proved to be weak points in the economic system back then, banks are capitalized much more strongly today. Whereas a vastly overheated housing market played a key role in the last crisis, today’s housing market is barely lukewarm. Whereas a temporary deflation characterized the last recession, benefitting government bonds, it’s certainly possible that the next recession may feature galloping inflation (such as in the early 1980s), which hurts bonds (and ultimately helps stocks). As a general rule, preparations for avoiding an earlier conflict or crisis frequently prove to be ineffectual for the future. That’s why an investor's best defense against investment risks is a knowledgeable analysis and assessment of the economic and investment environments, not a … portfolio of yesterday’s survivors. Successful investing isn’t easy, but we seek to apply sound analysis to today’s—and tomorrow’s—ever-changing environments.
…the Dow Industrials gained 347.62 points for the month of October , which represents a 2.04% return, not counting dividends. On a daily basis, this worked out to an average gain of approximately 15.11 points. If that was how October actually played out—a gain of 15.11 points per day—most investors would have been calm and happy. However, as you can see, the actual daily results in October were anything but uniform. There was a sharp 334.97 drop one day, followed by an additional 338.18 point drop over the next two days. That scared a number of investors, as sharp drops always do. However, there was also a net 1,273.28 point gain over an 11-day period later in the month. (These sharp up and down movements are not exactly supportive of the theory that market prices are “efficiently” determined.) With these results as background, we have two questions: (1) For everyone other than those with exceedingly short time horizons, what difference did it make that stock prices were volatile during the month? (2) More generally, given the strong returns historically earned by diversified portfolios of stocks over the long term, what difference does it make that stocks can be volatile over months, quarters or even years? As long as an investor has income from dividends (and/or other sources) and a sufficient buffer to preclude forced investment sales for living expenses, short-term volatility amounts to just one thing for the intelligent and emotionally stable investor—an opportunity to buy low. (Remember, in order to reduce the risk of forced sales, we maintain appropriately-sized cash/money fund buffers within client portfolios to address known withdrawal needs.) This is easy to say, but it’s not easy for many investors to accept. Indeed, there will always be those who develop overwhelming fears in response to stock market dips. Despite 100+ years of evidence to the contrary, these investors tend to see Armageddon behind news headlines and under every rock. Though these people are entitled to their own views, whether they have a basis in fact or not, it is important to recognize that there is a price to be paid for unwarranted pessimism.
Despite the short-term choppiness of stock returns, the long-term performance of stocks after both taxes and inflation has been significantly positive.
There seems to be no limit to the emailed articles from friends or friends-of-friends that contain seemingly alarming economic predictions based on the status of some alleged indicator. Never mind that more than half of the alarmist predictions use faulty or irrelevant data. Even when the data are real and seemingly relevant, we again urge caution. As [we've said], “Given long enough time and deep enough data, you can find a seemingly impressive linkage between almost any two factors. But correlation isn’t causation.” To illustrate the limits of such “data mining,” Harvard economist Greg Mankiw noted the following close (but nonsensical) correlations: (1) the divorce rate in Mississippi and the number of murders by bodily force; (2) honey-producing bee colonies and the number of juvenile arrests for possession of marijuana; (3) the per-capita consumption of mozzarella cheese and the number of civil engineering doctorates awarded; and (4) U.S. crude oil imports from Norway and the number of drivers killed in collisions with railway trains. Each of these pairs … has a statistically high correlation, yet none make any sense. They are the one-in-a-hundred exceptions that can be found if you look hard enough. Our advice is to beware of anything that comes in a mass-circulated email and also to beware of correlations that may seem less nonsensical but are still essentially random noise.
[We’ve] made the point that investors can choose to tolerate characteristic stock market volatility in pursuit of attractive long-term returns, or they can choose to tolerate significantly lower long-term returns in pursuit of more short-term stability. These are the choices available to investors, but since many don’t understand this tradeoff, they sometimes seek other alternatives. Consider annuities offered by insurance companies, for example. Annuities sometimes promise guaranteed minimum returns and equity-linked upside possibilities. However, insurance companies typically invest their annuities’ funds in stocks, bonds and real estate, and they simply cannot rewrite the tradeoff between expected risk and return. So it pays to read their fine print. Guaranteed returns are typically low in comparison to average equity returns, and “equity linked” returns often amount to much less than a one-to-one correspondence with S&P 500 total returns. Again, insurance companies aren’t magicians.
Economic and investment theories (and common sense) tell us that in order to accept greater risks, investors demand greater returns. Although we could make the case that over the very long term the risks faced by investors don’t vary that greatly, over the shorter term they do—at least, the perception of risk can vary greatly. If we want to test the theorized relationship between expected risk and return, we should search for historical periods when investment risks were perceived to be high (or low) and then look to see what returns were thereafter. The environment of the 2007–09 financial crisis and its aftermath would seem to be tailor-made for this purpose. After all, in the depths of that bear market investors were as worried as I have seen them in my lifetime. Economic and investment theory would say that stock returns from 2009 forward should have been higher than normal—and that’s exactly what they were. From the market bottom through August of 2014, the S&P 500 averaged an annualized return of over 20%, which is far higher than more normal 10% annual returns. Indeed, you could correctly say that the decline in stock prices, which was far greater than the decline in GDP, was simply the mechanism by which the stock market priced itself for high future returns. Put differently, low initial stock prices create the potential for large future returns, which is what investors demand when they are fearful. The amount by which future stock returns are expected to exceed the returns on very stable investments is known as the “equity risk premium.” Obviously, it pays to invest when the equity risk premium is high, and this means that it pays to invest when other investors are worried.
If you own one stock, your “portfolio” will almost assuredly be rather volatile. If you own two stocks, especially if they represent significantly different companies, overall volatility will be less. As you keep adding more stocks, near-term volatility will continue to decline, but at an ever-decreasing rate. Beyond some point of diversification, you will ultimately be left with characteristic stock market volatility, which simply cannot be diversified away. Thus, if your portfolio contains numerous stock mutual funds, each of which is diversified, you will not achieve a meaningfully lower amount of short-term volatility than, say, a portfolio of several dozen different stocks. However, a portfolio of numerous stock mutual funds is very likely to be unable to sufficiently differentiate itself (due to its very broad diversification) so as to outperform a benchmark index. Put differently, a portfolio of many stock mutual funds won’t add much, if anything, in terms of volatility reduction, but it certainly can—and likely will—constrain returns. Nevertheless, portfolios of numerous stock mutual funds (or exchange-traded funds) are sometimes marketed to appeal to the elusive low-risk, high-return objective. So are strategies of “tactical asset allocation,” “smart beta,” “private equity,” or a seemingly countless number of recycled approaches and gimmicks. However, at the end of the day, the data on investment returns is quite clear: Without 20/20 hindsight, investors simply can’t achieve predictable low-risk, high-return results, no matter what the marketers may say.
If we told you there was a tight correlation between U.S. GDP and the kangaroo population in Australia, you’d probably come to the same conclusion. However, at times specious correlations are not so obvious, because there seems to be an argument to be made that a cause-and-effect relationship exists—even if it doesn’t. F or example, just because the S&P 500 gained (or declined) more often than not when a given economic condition existed in the past, it is risky to draw the conclusion that the economic condition will again be followed by similar moves in the S&P 500 in the future. Perhaps, for example, it’s not the specific economic condition that led to stock market moves, but rather some other variable that accompanied the condition in question in the past, but won’t necessarily do so now or in the future. Another example of misleading coincidences would be the seeming similarity of stock price patterns. For instance, after the sharp stock market downturn in October of 1987, Alan Abelson, the former editor of Barron’s and perennial pessimist, delighted in comparing a chart of stock prices in 1987 to a similar chart of 1929 stock prices. Visually, the correlation appeared close. Until it didn’t. The aftermath of 1929 was the Great Depression, yet 1987 represented just a temporary interruption to a long period of economic growth. Forgetful of history, other pundits tried to compare stock prices in 2008 with those in 1929. That didn’t work either. For a while the correlation may have seemed close, but stock prices after 2008 bore no resemblance to stock prices after 1929. Understanding when correlation does result from causation (and when it doesn’t) is one thing that separates successful and unsuccessful investors.
While the common sense risks of hitchhiking may seem obvious, one interesting thing about investing is that common sense isn’t necessarily all that common. Indeed, some seemingly riskier investments have historically not proved to be particularly risky, while some seemingly safer investments have proved to be quite risky to an investor’s financial health … Experience suggests that the primary reason investors make ill-suited choices is that they typically act on perceived risks or safety, not actual risks or safety.
…let’s agree on a simple definition of risk. To us, risk is the likelihood (possibility, probability, etc.) that you will not be able to achieve your objectives. Therefore, the concept of risk is essentially meaningless without having some objective(s) in mind. For example, consider these possible investment objectives: (1) avoiding negative returns, (2) avoiding after-inflation negative returns, (3) avoiding after-inflation, after-tax negative returns, (4) making your money grow to the point that you have an adequate retirement nest egg, and (5) trying not to outlive your money. For many people, the first of these objectives is relatively easy to achieve, though it may come at significant cost in the form of very low nominal returns (and perhaps negative returns after-inflation). The second objective is harder, and the third, fourth and fifth objectives are increasingly more difficult to achieve. …A common perception is that stocks are basically riskier than most bonds and bank deposits. Put differently, the perception is that most bonds and bank deposits are safer than stocks. …[However,] if you want your investments to maintain (or increase) your purchasing power, or if you want to avoid outliving your money throughout your retirement years, then for many people bank deposits and most bonds are risky and stocks are safer. You read that right. Depending on your investment objective, bonds can definitely be riskier than stocks, because bonds often lack the rate of return potential necessary to achieve growth after inflation and taxes.
It is hard to underestimate the role of consumer, business and investor confidence in a market economy. Simply put, for there to be economic progress, people need to feel confident enough to buy durable goods (automobiles, appliances, etc.), start or expand businesses, and take the investment risks associated with business formation and job growth. Understandably, after a recession as steep as the one during 2007–09, confidence takes time to improve. That’s one reason why the current economic recovery has been slower to develop than others in our lifetimes. Importantly, it is often those individuals who are quicker to regain their confidence who benefit more when it comes to their own economic interests. For example, those who bought a new home in recent years benefited both from low home prices and very low mortgage rates. Those who invested in stocks over the last five years earned high returns. Although it may not warm the hearts of those who remained worried over the last five years, their bank account and money fund savings helped to keep interest rates very low. This enabled home buyers to acquire low-rate mortgages and enabled businesses to borrow funds cheaply, thus benefitting their profitability and stock prices. Indeed, low-rate mortgages and corporate borrowings have in many instances been locked in for decades, so higher interest rates at some point will not necessarily increase borrowers’ costs commensurately. In general, the fact of the matter is that those with low amounts of confidence unwittingly contributed to the success of those with more realistic outlooks. As in many things, it pays to have a realistic view of both the risks and opportunities in life.
As a practicing economist, I would like to emphasize that the considerable power of economics is in understanding how the economy works and how consumers and businesses react to various situations and incentives, not in short-term economic forecasting. Indeed, there is no body of economics experts with more data, experience and insight than the Federal Open Market Committee (FOMC), yet transcripts of FOMC meetings in 2008 make it clear that virtually nobody accurately foresaw the coming financial crisis. Moreover, among the numerous private economic forecasters, even the perma-bears failed to anticipate the severity of the 2007–2009 recession. Among the FOMC members known as “hawks” (those who maintained that little Fed intervention was necessary), their too-rosy expectations for the U.S. economy proved to be the furthest off the mark. Interestingly, among the FOMC members who seemed to best understand the realities of the recession was Janet Yellen, the current Chair of the Fed’s Board of Governors.
…a number of studies have shown that the average investor in a given mutual fund tends to achieve a lower return than the fund in which he or she has invested. How can this be? It’s simple, actually. Investors … add to their accounts when they feel optimistic and reduce their investment when they feel pessimistic (otherwise known as buying high and selling low) will typically earn lower returns than those who stay invested through thick and thin.
What matters much more than high-frequency trading to the average investor is what we’ll call high-frequency follies, which are the primary emphasis of this letter. For example, according to a recent Wells Fargo survey of more than 500 affluent investors (defined as having $500,000+ in investible assets), in reaction to the 2007–09 bear market, 21% of these investors have written off investing in stocks—for now, at least. Interestingly, of this 21%, more than a third would reconsider investing in stocks after they produce sustained positive returns. Say what? These investors are willing to invest in stocks only if prices first move considerably higher? Although this illustrates human nature, waiting until after stock prices have risen to the point that everyday investors feel more confident (rather than yesterday or today) is not a strategy that’s likely to produce good returns. Simply put, we’d call this approach a frequent folly.
…there has never been an S&P 500 bear market that wasn’t ultimately completely offset by a subsequent bull market taking stock prices back to their long-term growth trend. We’re making this point now, because there will undoubtedly be future bear markets (at unpredictable times), and many investors won’t be thinking too clearly at that time. We want to position ourselves to take advantage of others’ emotional reactions, not to succumb to our own.
While the long-term trend for the economy and stock prices has been—and remains—upward, it is virtually impossible to predict short-term swings in stock prices before the fact. The only realistic way to outperform, say, the S&P 500 in more normal environments is to selectively invest in good companies selling at attractive prices. This is much easier said than done, because the stocks of good companies seldom trade at bargain prices, and there are always false bargains among companies destined for poor operational performance.
Simply put, the key to strong results over the long term is to successfully compete—though not necessarily “win”—in the varied investment environments/events that present themselves over time: strong, normal and weak overall stock markets; strong, normal and weak years for various industries and stock market sectors (e.g., small, mid and large-cap stocks); strong, normal and weak years for competing investments and international markets.
Intelligent diversification works. However, problems can develop when an investor mistakenly assumes that merely adding more investments to a portfolio produces the desired diversification benefits. Simply put, when additional investments are not appropriate for an investor’s objectives, including them can add risk to a portfolio. This process has been labeled di-worse-ification by famed investor Peter Lynch.
…the investment environment is always changing, sometimes slowly and sometimes not so slowly, so the most useful approach remains to intelligently assess the environment, to diversify appropriately (though not mechanically or excessively) among investments suitable for the environment, and to carefully monitor one’s investments.
Simply put, investment returns over a few weeks, months or even years are not sufficient to project long-term results. Investors need to consider all of history, not just their most recent experiences. As a related point, every successful long-term investor will experience disappointing results for periods of weeks, months or years. Indeed, I can’t think of a single successful long-term investor (Graham, Templeton, Lynch, Buffett, etc.) who hasn’t suffered temporarily weak results. When investors seek perfection, they are likely to run into trouble.
People invest more than just their money. They invest their time and energies in countless ways, and there are some conclusions regarding investing that remain valid for virtually all of its forms. Perhaps most simplistically and effectively put, investing is most useful when it is consistently practiced with both purpose and patience.
We’ve seen many investors try this, but at least 90% have not been successful. When the outlook is better, stock prices will already be higher.
There are two basic forms of risk for investors: (1) losing money via depreciating investments, and (2) running out of money. ... If your investments earn insufficient returns to make your nest egg last as long as you do, you’ll run out of money—so it is vitally important to understand that those investments that are perceived to have the least short-term volatility typically have the worst long-term returns. What’s the difference between having no money because your investments depreciated and running out of money because your investments didn’t produce sufficient returns? Not much. Either way, you have no money. However, while losing money with a diversified portfolio over the long term is indeed rare, losing your money through insufficient returns is much more common.
As mentioned earlier, many tech stock prices became inflated in the late 1960s. However, that episode paled in comparison with the tech stock bubble of the late 1990s. (It took 30 years for investors to forget what happened in the 1960s, I guess.) The 1990s tech stock bubble is recent enough that I don’t think I need to dwell on its particulars, other than to say it represented yet another instance of real investment risk becoming very high, because most investors believed it was low—and ultimately becoming quite low (after the bubble burst) when most investors believed it to be high. One more point: After the miserable experience many investors had in stocks a dozen years ago, many decided to greatly reduce their stock investments in favor of something that always seemed to grow. That something was real estate, which then became overly popular by 2006. Thus, it is accurate to say that the severity of the most recent, real-estate-led recession was partly caused by yet another episode of investors fleeing what had previously performed poorly (stocks) in order to pursue what had already performed very well (home prices).
Here are a few timeless guidelines we think will help you walk along the path of investment success:
• As a result of continual advancements in science, technology and innovation, the long-term trend for stock prices has been and very likely will continue to be upward. It’s not enough to say this; you have to truly believe it.
• The best times to buy are when prices are low, but prices are low when there are obvious dangers and risks. Put differently, buying low means buying when most people, including you, are scared.
• A corollary: If an investment is popular, it is very likely high priced. Buying high is not the best investment strategy.
• The economic crisis of the day is temporary, but the pain of missing the investment performance boat can be permanent.
• If you think the average investor can find useful investment information in the newspaper, you are an optimist.
…with any amount of inflation, fixed income (or so-called “guaranteed” income) really guarantees a loss of purchasing power. Interestingly, we find that many investors seem to worry more about problems that come and go, like recessions, and less about problems that occur fairly continuously, like inflation.
In order to invest in the inflation solution, we hold investments ... that own important physical assets (electricity-generating dams, ports, pipelines, etc.) that create increasing cash flows and will likely be priced higher in inflationary times. We view investments in companies that own critical physical assets or that cost-effectively produce essential goods and services as important ways to invest during more inflationary times. Over the long term (1926–2011), a dollar invested in the S&P 500 has produced positive after-tax, after-inflation returns, but a dollar invested in T-Bills has lost value after taxes and inflation. Put differently, traditional savers (in bank CDs, T-Bills, etc.) bear the burden of long-term inflation. Because gold has not produced long-term returns comparable to stocks, does not produce earnings or dividends, isn’t essential for the most part, and seems already richly priced, we’re not planning on investing in gold under current or foreseeable conditions.
Not only is investing difficult in the best of circumstances (complete transparency of information, a clear future outlook, rational markets and investors, etc.), but most of us have certain inbred tendencies to process information with certain biases. For example, consider the mathematical expression “8!” This is pronounced “eight factorial,” and it’s equal to 1 x 2 x 3 x 4 x 5 x 6 x 7 x 8. Researchers asked a group of subjects to estimate 1 x 2 x 3 x 4 x 5 x 6 x 7 x 8, and their median answer was 512. However, when these researchers asked another test group to estimate 8 x 7 x 6 x 5 x 4 x 3 x 2 x 1, the median answer was 2,250. Since the product of a series of numbers is the same regardless of their order, it seems that the test subjects “anchored” on the first few numbers estimates. That is, they had an unconscious bias. This is just one example of how our minds can trick us. By the way, 8! is actually equal to 40,320.
Milton Friedman famously argued that “inflation is always and everywhere a monetary phenomenon.” So, should we therefore put most of the blame for inflation on the keepers of monetary policy (central banks like the Fed, the European Central Bank, the Bank of England, etc.), rather than on over-reaching politicians? The answer is yes—and no. (This type of economist-speak used to exasperate President Harry Truman, but please read on.) Yes, if central banks absolutely refused to expand the money supply faster than inflation-adjusted (“real”) economic growth, there would be virtually no inflation. So inflation is a monetary phenomenon, just as Friedman said. However, we should ask why central banks create inflationary money supply growth. After all, with a few notable historical exceptions, they’re not stupid. The simplest answer is that if they didn’t significantly expand money supplies, tax and spending programs (fiscal policy) would ultimately drive government finances to an untenable position. Governments might not be able to pay their bills, resulting in disruptive defaults. Faced with the choice of default-induced economic disruption or more inflation, central banks typically choose the lesser of evils—inflation. Put differently, when politicians don’t raise taxes or reduce spending sufficiently to provide for noninflationary economic growth, central banks allow the disguised “tax” of inflation to rob everyone of enough purchasing power to accomplish that which politicians are unwilling to accomplish more openly and directly. So one can make the case that it’s the taxing and spending policies of various governments that ultimately drive inflation. This explanation strikes us as being more realistic in most cases.
. . . our long-term strategy has remained consistent over the years: We try to take advantage of stock prices that have been driven unrealistically low (or high) by excessive fears (or hopes) generated by incomplete research, sensationalized media coverage or human nature. Put differently, we frequently buy investments that are temporarily and unrealistically out of favor. With eyes wide open (and lots of research), we buy stock in companies that are experiencing problems if we feel these problems are either temporary or exaggerated. Conversely, we sell companies that are experiencing solid operational growth if we feel such growth will prove to be temporary or that current stock prices are excessive, even if operational growth extends for a while. It may feel unsatisfying to buy companies with problems or to sell those reporting robust results, but the message of history is quite clear—this approach is more likely to work over the long term than buying the most popular companies and selling the unpopular ones. Why’s that? It’s primarily because human nature, reinforced by peer pressure, tends to assign overly low prices to out-of-favor companies and overly high prices to popular ones. This approach doesn’t work all the time, of course, and it may feel emotionally draining to buy unpopular companies only to watch their operations deteriorate further—or to sell popular companies only to watch their success grow beyond expectations. Indeed, the regret caused by a few instances of unsuccessful, unpopular actions typically drives the average investor to follow the crowd (and his gut), even though this typically leads to below-average results. In addition, that’s why some professional investors, including those who should know better, also feel pressured to follow popular sentiment.
Consider the case of a 25-year-old who decided to quit smoking a pack of cigarettes a day back in 1972 (40 years ago). Using reasonable assumptions for the cost of cigarettes (and cigarette taxes) over the last 40 years, if this person saved the cost of a pack-a-day in a retirement account that averaged 10% annual returns, he or she would have amassed about $140,000 by now. Such is the remarkable power of consistent saving and long-term compounding. There are many other examples of small efforts that can result in large cumulative returns. For example, the yearly difference between packing a brown-bag lunch to work versus buying lunch at a hamburger or sandwich shop can be in the same range as the yearly cost of a daily pack of cigarettes. Further, turning down just one cup of coffee per day at a specialty coffee store can result in similar savings. You can probably think of more examples. Cumulatively, the result of consistent small saving behavior over a working lifetime can yield large amounts for most Americans. Put differently, steady saving combined with patience and market returns is a winning combination. Of course, those who commit themselves to larger savings efforts through their 401(k)s, pension plans, etc., early in life can look forward to accumulating even larger nest eggs. We simply wish that more young people understood these important facts of financial life.
…those who aspire to earn typical stock market returns over the long term simply can’t afford not to be invested during sharp market recoveries. Put differently, if you want to invest only when the economic and political outlooks seem good, and if you want to sell when there are obvious clouds on the horizon, you might as well stick with Treasury bills and bank deposits—and watch your $1 grow to only about $4.40 over 50 years— because buying in good times and selling in bad times won’t do you much better.
As stressful as the current economic situation in Europe is [December 2011], the situation during World War II was many times worse. Yet, if you didn’t know when World War II occurred, you couldn’t figure out the war years by looking at long-term S&P 500 prices. Indeed, from the time the Nazis invaded Poland in 1939 through V-E Day in 1945, the S&P 500 gained about 85%. How can long-term stock prices not be negatively affected by something as momentous as World War II? The answer is that the forces of long-term advancement in science, medicine and technology—aided and strengthened by entrepreneurial innovation and incentives—are extremely powerful.
The risk of deflation seems to have passed, and economists are now asking whether inflation will move above the Fed’s 2% annual rate target. Food and energy prices combined have an approximate 23% weight in the consumer price index (CPI), and of these two factors we think energy prices stand a chance of accelerating, particularly if the economy continues to improve and the U.S. does not exploit its abundant supplies of natural gas. Housing has a 40% weight in the CPI, and it is measured by two indexes of rents, not home prices. With fewer people owning homes nowadays, the demand for rentals has increased, and therefore rents have started to rise. If CPI inflation remains above 2% for long, look for the beginning of the end of the current period of very low interest rates. That could be unwelcome news for bondholders.
People are getting the message when it comes to planning for retirement in today’s environment. According to a recent poll, 39% of workers don’t plan to retire until after age 70. We expect that number to approach 45–50% over the coming years, as workers deal with longer life expectancies and make more realistic assumptions regarding spending requirements in retirement. If everyday people can figure out that longer working careers are necessary and appropriate, why is it so hard for Congress to raise the eligibility ages for Social Security and Medicare? Like the Greeks (and the rest of the world), we can’t simply legislate pensions and benefits that aren’t sustainable. Probably the simplest, least disruptive and most sensible thing for Congress to do in order to increase retirement security is to adjust the Social Security and Medicare retirement ages—the sooner, the better.
When stock prices decline and eventually recover (and ultimately go higher)—which is what they’ve done throughout history—the price drops amount to little more than temporary declines. If you have the appropriate patience and time horizon, you’ll be fine. However, suppose you become rattled by a drop in stock prices and decide to sell “until things clear up.” Unless you decide to reinvest when stock prices are lower (and the outlook scarier) than when you sold—an extremely unlikely event—then your lost opportunities are likely to be permanent.
However, excessive optimism and excessive pessimism—bred by the same “this time is different” mindset—led to excessively high or low stock prices. Depending on your perspective, this is either good or bad news. It’s bad news if swings in investor sentiment cause you to buy high and then sell low. Yet it’s good news for patient investors who know what they’re doing.
Here’s one important lesson: Lengthening life expectancies are a fact of modern life. Within the last month I completed one of those online life expectancy calculators, which included questions regarding my age (62), sex, height, weight, diet, health, etc. According to the calculator, my life expectancy is another 24 – 26 years (age 86 – 88). That’s not a remarkable figure, given that I have already survived the first 62 years of my life and remain in good health. Interestingly, the online calculator did not ask how long my parents or grandparents lived. My mother is 90 and still alive, my father passed away two weeks short of his 89th birthday, and my grandparents lived well into their 90s. So perhaps my life expectancy is a bit longer. Between my wife and me, the odds that at least one of us will reach age 90 are better than 50 – 50. Using 90 as a conservative joint life expectancy, this means that fully half of all couples in similar situations will see at least one spouse live longer than 90 years. But who wants to plan on living only up to his life expectancy? After all, fully 50% of people will live longer. To be conservative, shouldn’t couples plan on living, say, five years longer than their joint life expectancy? In our case, that gets my wife and me planning for one of us to live to about 95. That is over 30 years from now, and it necessarily affects our determination of appropriate investments. For example, using data going back to 1926 (when detailed financial information became available), there has never been a 30-year period in which bonds performed better than stocks. However, there have been many 30-year periods in which stocks dramatically outperformed bonds.
Living a long life represents a ... kind of risk, and approximately half the population will live beyond the national life expectancy. Indeed, some will live significantly longer. These individuals will likely need a larger than normal nest egg to support themselves over their longer lives, so how are they going to build such a nest egg? They’re unlikely to do so by continually focusing mainly on rare risks—financial earthquakes. Rather, they need to emphasize the returns earned by a long-term, intelligent investing program. For many investors, that includes stocks.
Science and all forms of knowledge inevitably march forward, and knowledge mixed with opportunity and entrepreneurship create economic growth. Economic growth helps fulfill humanity’s aspirations—and it rewards those who help bring it to fruition.
I just finished a phone conversation with a client. This individual, like many investors, is concerned about today’s economic and political climate. As the client rattled off concerns, I couldn’t help but think that virtually every worrisome condition today has occurred in a similar (or worse) form in the past—frequently within our lifetimes. I’ve lived through (or studied) many periods of general pessimism, and I can tell you this: Despite occasional very major problems (a Civil War, two world wars, a Great Depression with 25% unemployment, galloping inflation, sky-high interest rates, and crazy politics and politicians), to date every recession has ended—and been followed by new highs in GDP. Further, every bear market has ended—and been followed by new highs in the S&P 500. I like that record.
If investors had a good sense of when the stock market would rise or fall, it makes sense that they would buy low and sell high. However, economic history tells us that investors more typically buy high (when they are feeling optimistic) and sell low (when they feel pessimistic). It should be obvious, therefore, that investors generally do not know what stock prices will do in the coming weeks or months. Indeed, what stock prices do over the short term is more typically the opposite of what investors expect. We hope investors will think about that the next time some TV guru suggests they sell their stocks and buy gold.
Think back to early 2000 for a minute. The S&P 500 had just completed five years averaging over 25% annual returns, and most investors felt quite bullish about the “new economy.” What happened next? The S&P 500 declined about 40% over the next 2 – 3 years. As a result of the market’s decline, many investors then turned bearish. What happened next? The S&P 500 gained about 100% over the next five years. After that gain, investors became bullish again. What happened next? The 2007 – 2009 stock market decline. As a result of that scary experience, many investors became quite bearish. After that spike in pessimism, what happened next? The S&P 500 produced sharp gains over the following year. Today, with the S&P 500 down over 15% from its April 2010 high, the pessimists are out in force again. What do you suppose will happen next? Call us crazy optimists, but we’re confident pessimism will crest at some unpredictable point (unrecognizable at the time), if it hasn’t already, and the stock market will rise once again. As old and consistent as this cycle of investor sentiment and stock market returns is, some investors continue to sell at lows, when they feel pessimistic, only to buy again when they’re feeling better at market highs. Our job is not to follow this madness, but rather to take advantage of it.
Right now many investors feel pessimistic, primarily as a result of the stock market’s decline from its April highs. Further, the economy (especially employment) isn’t growing as fast as many would like, Europe has fiscal problems, the U.S. political environment looks unhelpful, “high frequency” trading seems to lead to bolts of volatility out of the blue, and China’s growth may be slowing. Each of these concerns is valid to a degree; however, there are always legitimate concerns facing the economy and the markets. Likewise, there are always legitimate reasons for optimism. In the final analysis, the reality is that after the stock market has declined for a while, many investors focus on pessimistic possibilities, and after the market has risen for a while, their focus turns to optimism. Virtually nothing in investing seems to be as consistent as the connection between recent stock price moves and investor sentiment, yet few investors have learned to exploit the vagaries of investor sentiment. Simply put, the best time to buy stocks is generally when prices are low—that is, when investors are giving extra emphasis to the ever-present problems of the world. The best time to sell stocks is when prices are high—when investors are especially optimistic. As counterintuitive as it may seem, when investor sentiment is bearish, subsequent stock market results tend to be better than average. As a corollary, when investor sentiment is bullish (and prices are high), subsequent results tend to be subpar. Anxiety, it turns out, is frequently a contrary indicator.
Investors appropriately ask lots of “what if ” questions. For example, what if countries don’t take better control of their finances? Countries that don’t control their own currency (like Greece, which uses the Euro) or have borrowed funds denominated in foreign currencies cannot inflate their way out of their fiscal problems. Thus, either they practice fiscal discipline or they default on their debt (“restructure”)—which would lead to a lack of access to further borrowing, which would likely lead (finally) to market-enforced fiscal discipline. Countries that do control their own currency (like Japan, the U.K. and the U.S.) can either practice fiscal discipline or print sufficient money to pay their debts. Printing money, of course, would likely lead to inflation and possibly a 1980-style election where inflation concerns dominate the political agenda. If we experience meaningful inflation again (something that hasn’t happened in about 25 years), that would likely increase nominal stock returns, home prices and energy prices; leave inflation-adjusted stock returns roughly the same; and decrease bond returns (potentially to the point of being negative). Basically, inflation acts much like a tax that takes purchasing power from consumers. As you would expect, we closely follow inflation trends.
Sometimes we’re asked what we’ve learned from the last few years. There are many things that we better appreciate, but two stand out in my mind: (1) When consumer and investor emotions—both fear and greed—are strong enough, they are capable of moving the economy and stock prices in ways that traditional economic analysis wouldn’t anticipate or predict; and (2) whatever has happened recently dominates many people’s assessments of their investment results.
We don’t want to leave the impression that only pessimism can be taken to extremes. Before the tech stock bubble of the late 1990s, there was a tech stock bubble in the 1960s, a “nifty-fifty” stock bubble in the 1970s, a gold bubble around 1980, a housing bubble just a few years ago, and so on. Of course, none of these bubbles seemed so extreme at the time to most people. There’s an important message for investors in this history: Investments that feel safest at the moment are frequently the most dangerous, and those that seem the most uncertain often become the most rewarding. “Buy low and sell high” essentially means buying irrationally unpopular investments and selling unduly popular ones. Because crowd psychology often exaggerates investment price swings, the crowd is frequently wrong. Yet crowd behavior feeds on itself over the short term, thereby increasing the sharpness of the inevitable correction. Right now we sense that the crowd is overly cautious, and believe it or not, we expect crowd psychology to reverse and become over-exuberant at some point. After all, it’s happened dozens of times before.
. . . consider the recession of the 1990s and its accompanying bear market. Or the Y2K scare. Or the post 9-11 situation. Or the stock market crash of 1987—down 22% in just one day. Or the savings-and-loan crisis. Or the various junk bond crises. Or the [fill in your choice for worst President] administration’s various blunders. The list goes on. Of course, none of these believable-at-the-time scares significantly dented the long-term progress of the U.S. economy—or the stock market. Yet to judge by investors’ fears at each juncture, the future course of American prosperity was anything but obvious to many people. Each scare seemed very real at the time and was accompanied by nervous investors selling stocks (often near market lows) and running for perceived safety elsewhere. (Not that they necessarily found safety elsewhere.) Each scare—accompanied by the latest “this time is truly different” disaster story— seemed to refute long-term economic growth. For a while, that is. Yet eventually—without fail in our history—investors ultimately found themselves pleasantly surprised that economic growth resumed. Despite a historical record of over 200 years of long-term economic growth that has overcome substantial near-term problems—think of the Civil War or the Great Depression, both many times worse than anything in recent years—many investors were surprised each time when history repeated itself. . . . What we learn from history, as Benjamin Disraeli noted, is that we don’t learn from history.
. . . a group of test subjects was given 20 one-dollar bills and offered 20 chances to bet on a coin flip. If the coin landed heads, the subjects received $2.50, and if it landed tails, they lost their $1 bet. This is a great deal, because over 20 bets, the most likely outcome is for subjects to earn $15—in addition to their original $20. That’s a 75% return. It turns out that virtually all test subjects accepted the bet for the first five plays. Statistically speaking, the odds were that each participant would win two or three of the first five coin flips. However, chance being what it is, some participants won—or lost—four or five of the first five plays. Despite the clear 50/50 nature of the bets, those subjects who lost four or five times subsequently became reluctant to play as often going forward as those who had better initial outcomes. That’s the way it is with investing, too. Investors who experience unexpectedly disappointing results will sometimes decide to stop investing, even though they may acknowledge, intellectually, that their future prospects for investing success are as good as ever. Indeed, because the low stock prices that follow bear markets often set the stage for above-average returns in the next bull market, in the investing arena, the odds for success actually improve after bear markets. However, with the memory of investment pain fresh in their minds, some investors will pursue inferior investment alternatives in an attempt to feel better. For feeling better, there are lots of choices. For doing better, there typically aren’t.
We’d like to emphasize that the plunge in jobs and economic activity that began in late 2008 didn’t need to happen to satisfy the gods of economics. Rather, the steep acceleration in job losses and the decline in stock prices were born of consumer and investor panic. Although the panic helped CNBC ratings, it wreaked havoc on the economy, contributed to thousands of additional job losses, and cost many investors dearly.
In an era of increasing life expectancies, the retirement age for the average worker is apt to increase steadily. Indeed, of all the expectations we are discussing, this is the one we feel the most confident about. In terms of the average retirement age, 70 will likely become the new 65. We know that not everyone can work to age 70, but many others can (and will) work past 70. Importantly, this one change will do more to help the economy and favorably address issues like tax rates and pensions than any other change we can imagine. For those who mourn losing some of their expected retirement years, they might take some consolation in knowing that even retiring at 70, most people will enjoy longer retirements than most generations throughout history. Of course, those who enjoy their work are in the best position.
Now that people are less concerned about the end of western civilization, we get calls expressing concern about rising inflation, so let’s apply some economics and discuss this possibility. Simplistically, inflation results from too many dollars chasing too few goods. Put differently, when the demand for goods and services grows faster than supply, prices rise in order to ration existing supplies. Right now, and for the foreseeable future, demand is too low to trigger significant inflation. Further, with factories operating at relatively low levels of utilization, the supply of most goods is not constrained. Yes, the Federal Reserve has increased the money supply, but much of that money is not being used to buy goods and services. (Technically speaking, the money supply’s “velocity” is down.) If demand were commensurate with the money supply, the economy would be booming—and the Fed would be taking steps to restrain money supply growth. There is (always) a possibility of rising inflation down the road, but whether or not inflation increases significantly will depend on things that have yet to occur. Anyone who claims to be sure that inflation will shoot upward is kidding himself (and perhaps his audience). If government spending and money creation spiral out of control, then inflation will be a risk. However, if that were to happen, smart investors would want to own stocks of companies with pricing power. We are already there.
Importantly, although near-term market movements can’t be predicted, bull markets typically don’t end amidst a lot of investor caution. Bull markets usually end as optimism peaks, just as bear markets end when pessimism peaks (as happened earlier this year). The quick regeneration of investor caution with each bull market pullback is a healthy sign, as this caution regenerates the pessimism “fuel” that powers markets higher as it is gradually converted into optimism (through investor buying). Indeed, you might view periods of rebuilding caution as a kind of “fruit of the gloom” that extends bull markets. In a similar vein, when market pullbacks don’t create investor fear, that’s the time to become more cautious.
. . . from the market’s close on Feb. 27th through its close on August 7th, the S&P 500 gained about 39.55%. As you can see, anyone who sold near the panic low of early March missed considerable returns. Further, those who decided to sell anytime since October 7, 2008 have seen the stock market move higher, not lower. This is significant, because industry statistics indicate that the lion’s share of investors that bailed out of stocks during the September – March panic did so after October 7th. Put differently, although people who sold thought they were reducing their risks, unless the stock market accommodates them by dropping a lot from today’s level (something we doubt), they have missed years of returns in a matter of months. While it may seem risky to hold stocks—especially during recessions—history clearly tells us that it is often more risky to sell. We made this point to our clients, and the large majority took our advice. While we were doing our best to talk nervous investors off panic’s ledge, various media reporters and commentators published rumors and deeply flawed analyses almost daily—essentially shouting, “Jump! Jump!” Investors should reflect on this experience and ask, as Telly Savalas’ detective character, Kojak, used to say, “Who loves ya, baby?” Investors looking for love in the form of investment help or guidance from media reporters are looking for love in all the wrong places.
Bull markets usually end when investors are optimistic—even complacent. On the other hand, bull markets continue as investors’ pessimism from prior bear markets gradually dissipates. Right now, as evidenced by the very high (and slowly declining) levels of money fund deposits, many investors are still cautious, if not outright worried. A recent Barclays Group survey showed that 68% of investors feel there aren’t significant investment opportunities in the current market; 20% feel there may be significant opportunities, but the risk of further falls is still too high; and only 13% feel there are significant opportunities at present. Throw us in that briar patch—please—because investor caution/pessimism is basically the fuel that, when gradually converted to optimism, powers bull markets.
The 2007 – 09 declines in the economy and the stock market may seem to be completely related. Although the recession has been one of the worst, the decline in the stock market was far greater than we can logically attribute to a temporarily weaker economy. Indeed, throughout history it has been normal for stock markets to overreact to economic developments—because people frequently overreact. For example, between 1995 and 1998, net inflows into technology stock mutual funds averaged maybe $0.1 billion per month. However, in 1999, tech stock mutual fund inflows grew to $1 billion monthly—and then they grew to $2 billion and eventually to over $5 billion. In the December 1999 – February 2000 period, tech fund inflows jumped to an amazing $10 billion per month—100 times the 1995 – 98 levels. Is it any surprise that tech stock prices skyrocketed in 1999 and early 2000? More recently, in late 2008 general equity fund net outflows reached their greatest levels in history—and that’s one important reason why stock prices plunged late last year. As history makes quite clear, dramatic swings in investor confidence—apart from the much smaller swings in GDP—primarily cause the volatility in markets that investors mistakenly attribute to recessions, inflation, deflation, political meddling and other secondary factors.
. . . the unemployment rate typically peaks either at the end of a recession or after its end. That’s why unemployment is called a “lagging” economic indicator. (The stock market, which normally improves before the economy does, is a “leading” indicator.). ... If you focus on unemployment rates, you will typically be late to stock market rallies. If you focus on stock prices more than company fundamentals, you will probably find yourself whipsawed by normal market volatility.
Very simply put, the outlook for economic growth similar to that of the last 25, 50 or 100 years is excellent, because the factors that brought about historical growth (advances in science, technology, medicine, business methods, productivity, innovation, entrepreneurship and relative political stability) continue to operate in much the same way they have for many years in our nation of opportunity. Yes, every recession—including the present one—has had its own unique attributes, but none of these conditions in the past has been able to permanently disrupt economic growth.
Although it may seem to make sense for a given individual to run for safety if he is overly fearful, should enough people try this, the result is safety for no one. Thus it became necessary for governments around the world to take steps to address consumer and investor confidence.
If the last 100 years are a guide, it is dangerous for investors to assume that either hyper-growth or stagnation/decline will continue indefinitely. In the late 1990s, the S&P 500 averaged a 30% annual return over three consecutive years, but that ended in a bear market. Earlier this decade, home prices rose much faster than normal for several years, but that ended in a housing bust. On the other hand, stock prices have periodically stagnated or declined for a number of years, but bear markets were followed by bull markets. Investors who are swayed by recent events are at a disadvantage compared to those who study—and learn from—the important lessons of history.
Although psychologists say it’s human nature to extrapolate the immediate past, I hope investors resist that urge, because history is clear that both bubbles and panics ultimately—and irresistibly— are drawn back toward economic reality. And reality has been that for over 100 years, long-term economic growth has continued within sustainable limits, driven by advances in science, technology, innovation, entrepreneurship, risk-taking, capital (equipment) formation and freedom. Nuclear Armageddon or other draconian scenarios notwithstanding, the smart bet remains on economic progress.
In our judgment, recent market declines have been caused not so much by corresponding declines in worldwide economies as by today’s panicky crisis of confidence, brought about in part by some legitimate economic concerns, cheerleading by self-interested parties, a sensationalist press, and the political process. If history is any guide, our economic problems will be resolved (though not overnight). . . . Unlike the overall economy, stock prices can move quite rapidly over the short term, so when an upturn begins, it could be dramatic.
One of the questions we're frequently asked is, "When will the market stop declining?" Since nobody can know the precise answer to this question, perhaps it would be helpful to discuss what market bottoms look like. Market history teaches us that a bottom typically looks like anything but a bottom until well after the fact, and most people won’t recognize one as it occurs. Instead, as the market starts to recover, frequent sharp pull-backs keep most investors worried that the bottom is still in the future.
Throughout the history of U.S. stock trading, all bear markets eventually ended, and all were followed by up markets. Further, the unmistakable long-term trend of the U.S. economy (and, thus, the stock market) has been upward. Unless some future development occurs that’s more impactful than two world wars, a Great Depression, dozens of recessions, high and low interest rates and inflation, shortages and surpluses of virtually every commodity, and political machinations of all sorts, the long-term economic future should resemble the economic past.
Historically, the best way to achieve long-term investment success has been to buy good companies at attractive prices and then—contrary to human instinct—practice patience.
…our ancestors learned through trial and error that it was better to run first and think second. After these sorts of experiences have compounded for a thousand centuries or so, it is no surprise that today we are hardwired to react before we think—to use emotions before reason. Thus, when the S&P 500 undergoes a significant short-term decline, most investors experience an emotional response rather than a logical one—despite overwhelming evidence that emotional investment reactions are more apt to hurt than help.
Along the road of progressively higher long-term stock prices, there have been dozens of bull and bear markets. Although some bear markets have been steep (the S&P 500 declined over 40% during 2000–2002, for example), every bear market has ended at some point. Further, every bear market was followed by a bull market. And every prior bull market peak has ultimately been eclipsed by a higher peak. Indeed, the long-term pattern of the stock markets has been higher highs and higher lows.
So what do market bottoms (or those for individual stocks) look like? Typically, they don’t look like bottoms at all. They look and feel like the actual bottom is far lower—thus creating a peak in pessimism that’s necessary for a bottom to form. …the vast majority of investors, including me, won’t recognize a bottom until it’s visible in our rear view mirror. Many will try to predict a bottom, but their chances of success are about the same as a broken clock showing the correct time.
So what does drawing a line in the sand [to sell after a decline of] 50% do for you? It prevents a larger decline, but it can also prevent a very satisfying recovery. Here’s the bottom line: There is no magic line in the sand. That is, there is no arbitrary pullback (small or large) that should itself trigger a sale. The best time to sell is when your long-term view of an investment’s intrinsic value is such that today’s price doesn’t offer sufficient reason to remain invested.
Investing is always a very humbling experience, and while we focus on both our winners and our losers, we have always focused more on the losers. As much as I would like to assure clients that the lessons we’ve learned over the years will greatly diminish the volatility in our absolute or comparative results, that is simply not possible for any manager to do.
One plausible definition of risk is the chance of losing money over the period of your investment objectives. For example, if your goal is to achieve a competitive return over 5, 10, 15 or 20 years, and your account has declined in value (apart from withdrawals) over that time, then the risk of loss of principal has been realized. A better definition of risk is the chance of losing purchasing power over the period of your objectives. An example would be an investor whose account earned a return that was positive, but less than the rate of inflation. Yet another way to define risk is the chance of not fulfilling your expectations—for example, failing to beat inflation by some given amount.
Unless long-term economic growth is permanently halted by some event worse than any in our history, the outlook is for record high after record high occurring irregularly into the future. In the meantime, markets will continue to act irrationally over the short term and much more rationally over the long term. Short-term irrationality doesn’t worry us, of course, because our success in investing has depended on being able to take advantage of short-term distortions. Further, lower prices today typically lead to higher returns in the ensuing market recovery.
As even casual reasoning would suggest, diversification can be both good and bad. On one hand, it reduces the risk that unexpected events will lead to below-average portfolio performance. On the other hand, it also reduces the opportunity to achieve above-average performance—by including progressively less attractive investments in a portfolio and, eventually, creating a portfolio that looks increasingly like the overall market. Belief in unlimited diversification is ideology, while a consideration of the appropriate degree of diversification is analysis ... meaningful diversification involves much more than simply picking investments from different industry classifications. It requires a much deeper knowledge of how companies operate in different interest rate, economic growth, energy price and credit spread environments.
Simplistically speaking, there are only two things that matter when it comes to selecting good investments—today’s prices and future prices. Today’s prices are easily knowable, so that leaves future prices as the most important determinants of investment selection… Basically, most successful investors look at stocks not as mere daily numbers, but rather as certificates of company ownership. It stands to reason that the value of, say, a 0.01% ownership of a corporation will be 0.01% of the overall value of the corporation, so now we have an appropriate goal for investment analysis—to determine the overall future value of a company.
Long-term risk can be thought of as the possibility of a permanent loss of capital or, my preferred definition, as the possibility of not achieving one’s investment objectives. ... Basically, the concept of long-term risk is very much a function of one’s investment objectives. If your objectives require meaningful portfolio growth, it would be risky to consistently hold non-growth investments.
Importantly, investors who are at least aware of common psychological traps stand a better chance of making successful investment choices.
Although longevity is an important consideration, you’d be surprised how many people seem convinced that a nest egg that’s five or ten times their estimated annual retirement spending will be sufficient. In reality, over 25 years of retirement (or more), it probably won’t be. Further, experience suggests that at least 90% of us underestimate our actual spending. ... While the exact nature of unexpected expenses can’t be anticipated, most people fail to budget for unexpected expenses at all—and that can be a big mistake. Put differently, it’s important to generally expect the specifically unexpected. Further, logic dictates that the longer you plan to use your retirement nest egg, the larger it should be. (I suggest about 20 times annual expenses.) ... the longer your retirement funds need to support you, the more appropriate it is to choose a conservative rate of withdrawal.
Basically, in bull markets all news is interpreted as good news, and in down markets all news is interpreted as bad news.
You can experience fewer and less severe downturns if you are willing to give up a significant portion of your long-term return. Judging from market history, you might give up about half of the return of a typical equity portfolio in order to meaningfully reduce short-term volatility.
Program trading is technically defined as the purchase or sale of “baskets” of at least 15 stocks worth at least $1 million. In more practical terms, program trading sometimes seeks to exploit small—and frequently temporary—differences in stock prices. As you might infer, program trading has very little to do with long-term reasoning. Stock price moves caused by program traders, therefore, are normally uncorrelated with long-term economic reality. Soooo . . . what amount of trading on the New York Stock Exchange (NYSE) do you suppose is accounted for by program trading? Is it 5%? 10%? Would you believe that over half of all NYSE trading is the result of program trading? Amazingly, this is the case. Given that a majority of stock trading is based on very short-term factors, not on long-term fundamentals, is it any surprise that short-term prices exhibit significant volatility? As unsettling as large stock market moves may seem to some, successful investors just don’t worry about volatility. Instead, they use it to their advantage by buying when a stock’s price temporarily becomes unreasonably low. Then they practice patience and eventually sell at a reasonable price—or perhaps even an unreasonably high one. Volatility is the patient investor’s friend.
Indeed, the never-ending search for beatable benchmarks seems to have created a cottage industry in custom benchmarks. Concerning benchmarks and performance, I’d like to make two points. First, we have always used the S&P 500 as our investment benchmark. Second, I’d like to reiterate our conviction that over the short run, results may not matter; however, over the long run, only results matter.
Because real-world stock portfolios incur costs for transactions and management, while the S&P 500 reflects no costs whatsoever, any portfolio that’s reasonably close to the S&P 500’s composition is almost guaranteed to lag this index… Simply stated, portfolio managers who want to beat the S&P 500 over the long term must create portfolios that are significantly different from the S&P 500.
A more significant battle currently rages between stockbrokers and investment advisers. Stockbrokers, even those who refer to themselves as consultants or financial advisers, are often regulated as salespeople, whereas investment advisers are typically regulated as fiduciaries. Securities salespeople owe certain responsibilities to their customers; however, placing their customers’ interests first is not necessarily one of these responsibilities. Fiduciaries, on the other hand, are subject to the more significant requirement of placing their clients’ interests first. ... Justly or unjustly, some fiduciary advisers have concluded that broker-dealers really don’t want to be held to fiduciary standards for significant parts of their services. As for us, we think investors need advisers who place their clients’ interests first and who are highly competent. In short, investors need advisers who will not betray their clients’ trust or expectations of quality advice.
Simply put, monthly stock market returns have almost nothing to do with changes in the economy or corporate profits. In contrast, long-run stock market returns have everything to do with economic growth and corporate earnings. Smart investors focus on long-term investing, because long-term economic changes can be researched and analyzed. Short-term “investing” can be a dangerous game to play, because … it is virtually impossible to predict Mr. Market’s mood swings.
Economic growth is primarily a product of the advances in productivity that have come rather naturally from the free economic and political environments in our country. Put differently, economic growth is really a product of the enterprising human spirit. As for the future, as long as our freedoms endure, there is every reason to expect that our economic outlook will continue to be bright, despite periodic down markets and negative news stories.
Waiting for a rosy outlook is like waiting for the perfect investment. Searching for the perfect stock—one with little risk, a promise of excellent returns, a highly competent, shareholder-oriented management, and a bargain price— is likely to be unproductive and disappointing . In today’s semi-efficient markets, the reality is that wherever most investors see low risk and a very promising operational outlook, stock prices are likely to be too high to provide either a high return or a relatively safe one. Further hindering the search for the perfect investment, shareholder-friendly company managements are not especially plentiful.
Given that some academics have promoted indexing with near-religious zeal, it is to Wharton professor [Jeremy] Siegel’s credit that he hasn’t let conventional wisdom and beliefs get in the way of reality—and the reality is that capitalization-weighted indexes, such as the S&P 500, consistently overweight overpriced stocks and underweight bargain investments.
Suppose that Jack Smith retired at the beginning of 1973, invested his retirement nest egg in the S&P 500, and withdrew 5% of his initial balance, adjusted for inflation, each year. As it turns out, Jack would have exhausted his portfolio in less than 20 years. Now consider the case of Jack’s younger brother, Frank. Frank retired at the beginning of 1975, also invested his retirement savings in the S&P 500, and also withdrew 5% of his initial value, adjusted for inflation, each year. After 20 years, Frank’s portfolio would have grown to nearly eight times its original size. Are you surprised how large a difference just two years can make?
I could go on (and on) listing economic factors that get press when markets decline (and that are largely ignored when markets rise), but I think you’ve caught my drift. Our economy simply doesn’t change quickly, although Mr. Market’s whims—which aren’t bound by economic forces—can turn on an emotional dime. More accurately, his whims aren’t bound by these forces over the short run. Over the near term, therefore, stock prices can and will fluctuate out of proportion to changes in the economy. Over the longer term, however, Mr. Market is a veritable slave to the power of economic forces. Indeed, it is precisely the difference between Mr. Market’s short-term inattentiveness to economic factors and his longer-term yielding to them that creates investment opportunities.
Logical decision-makers typically ignore sunk costs—that is, they are said to think and make decisions “at the margin.” However, as behavioral finance researchers have shown us, logical reasoning can be anything but common among both consumers and investors. This is unfortunate, because if there’s one error in reasoning that trips up many investors, it’s the inability to ignore sunk costs. If, for example, you find yourself thinking about the price you paid for a stock more than thinking about its future outlook, then you should read John’s latest commentary, Spilled Milk ... John’s article is clear, easy to read and ‘spot on’ a most important and relevant topic.
Sometimes I like to…reinforce the intellectual arguments for investing in the manner that we do, and sometimes I prefer to discuss the importance of having the right psychological mindset for investment success. I divide my emphasis between intellectual and psychological factors because investors simply will not succeed without the right intellectual foundation and the right mindset. When making this very point, Warren Buffett has stressed that maintaining the right frame of mind is the harder thing to do. Notice the use of the word “maintaining,” rather than “having.” Many investors have the right psychological orientation most of the time. After all, most people understand that a long-term outlook and the willingness to take advantage of emotionally-driven price swings are essential elements of investment success. However, for many investors this intellectual knowledge fails them precisely when it is most needed—during unusually volatile markets.
A good investment environment for us is one in which we have opportunities to buy underpriced stocks and sell overpriced ones—i.e., an environment of moderate volatility. Although some investors prefer lower volatility to higher volatility, I don’t think they necessarily appreciate that with lower volatility come lower returns, because with lower volatility there are fewer opportunities to buy low and sell high.
Advances in science, medicine, technology and productivity have been firmly in place for a long time, and they represent powerful and undeniable forces. In the final analysis, long-term growth is the norm, and temporary economic setbacks are like the smaller waves of an advancing tide.
…not all investments are equally attractive. Assuming that we choose to buy the most attractive investments first, as we continue to expand our portfolio of investments, the expected return will decrease—as we add progressively less attractive investments. Further, while additional investments would reduce risk, each additional investment would reduce risk by a progressively lesser amount. (Adding an additional stock to a one-stock portfolio reduces risk by much more than adding one stock to a 100-stock portfolio.) As we continue adding investments to a portfolio, at some point the reduction in risk created by additional investments is outweighed by the reduction in expected return caused by adding investments with progressively lower expected returns. That’s when diversification becomes di–worse–ification (a term coined by Peter Lynch).
Although one could study economics and investing for many years (I have), I can summarize an essential truth about stock returns in a single sentence:
A stock’s (or portfolio’s) return can come from only three sources: earnings growth, dividend yield, and valuation change.
…the more extreme stock prices become in the short run, the more opportunities we have to buy cheap and sell dear. Indeed, I would go so far as to say that without the periodic volatile price swings of the last 11 years, we would not have averaged investment returns as high as those that we actually achieved. In short, for the careful investor, volatility is good.
…investing is inextricably linked to risk. If there were no risks, there would be virtually no returns either. Indeed, investment returns may very appropriately be thought of as compensation for the intelligent shouldering of risk. If we want to achieve meaningful returns, we must accept and manage risk. Risk, of course, is the opposite of certainty. Therefore, when we acquire a portfolio of investments (each with some degree of risk), it is unrealistic to assume that all of our investments will ultimately perform as we had expected when we purchased them.
Another important reason that the average investor typically underperforms market indexes is that he seems continually drawn to popular investing concepts. If there’s a mortal sin in investing, then following the crowd is it. After all, investor confidence is a coincident indicator—that is, confidence tends to be high when investments are (already) highly priced, and it tends to be low when investments are low-priced. Indeed, many investors have a habit of following one popular investment concept with another, typically just in time to buy high and sell low.
While patience is good, it makes little sense to continue to hold an investment once its fortunes have permanently changed for the worse—that’s stubbornness. How is an investor to know when holding an investment amounts to patience or stubbornness? Chances are that the average investor will focus on the prices of his investments and make his investment decisions on that basis—rather than focus on the health of or outlook for the companies of which he’s a part owner. This, dear clients, is a disastrous approach to investing. (It’s also a major reason why the average investor performs so poorly.) Simply put, watching daily prices won’t tell you what you need to know. Nevertheless, when there’s little else that the average investor knows about his investments, prices are often what he looks to.
Successful investors must have the courage to be different and the skill to be right.
One of the hallmarks of our contrarian investment style is that we remain flexible in our pursuit of bargain investments. Over the period of our track record, our managed portfolios have typically featured lower price/earnings ratios, smaller market capitalizations, and less focus on the manufacturing, health care and high technology sectors than the S&P 500. In the future, however, we could (and would) emphasize larger or smaller market capitalizations or change our industry concentrations if different sectors of the market appear attractively priced at that time.
Just as bear markets create opportunities for us to buy at unrealistically low prices, bull markets frequently provide us opportunities to sell fully valued stocks—in order to redeploy our clients’ assets into more attractive investments. Thus, we view market fluctuations, including sharp fluctuations, as good. Indeed, if the equity marketplace had provided a constant rate of return from the inception of our track record to the present, I’m convinced that our long-term investment performance would have been less than what we actually achieved. That’s because market volatility works to the advantage of patient investors who have done their homework and are prepared to buy bargain priced stocks during the marketplace’s periodic ‘sales’ and to sell richly priced investments when they are swept up in more enthusiastic periods. (That’s easy to say, of course, but not so easy to do.)
Over the years we have consistently used the S&P 500 as our benchmark for growth accounts, mainly because it is a long established, well known and frequently used measure of the equity markets. After all, since our clients typically hire us to pursue equity investments, measuring our performance relative to one of the most widely followed stock indexes makes sense. Further, I would argue that there isn’t a clearly better benchmark, even though the S&P 500 is primarily composed of the largest companies, while the investments that we’ve chosen for our clients typically average smaller market capitalizations (though they run the gamut from pretty small to very large). Company size, after all, is only one variable that affects the comparability of our managed portfolios with a benchmark. Other important—indeed, probably more important—factors include valuation levels, industry concentrations and a variety of other factors. All factors considered, I doubt that there is a more appropriate benchmark (for growth accounts) than the S&P 500, let alone one that most investors would recognize and find useful.
…the long-term direction of inflation is crucial in the analysis of bonds. If inflation is on the cusp of a prolonged rise, as I think it is, then bond returns will plunge and bond investors will feel as if they are swimming up a brisk stream.
…during the 1985 – 2000 period, the percentage of 54 – 65 year olds that worked grew gradually—at 0.40% per year (probably reflecting longer and healthier life spans). However, in the last few years the percentage of 54 – 65 year olds that are working has increased significantly faster. If I’m right, the labor force participation rate (LFPR), which refers to the percentage of a given age group that is employed, for older workers will continue to rise—especially for those over 65. In order for many senior citizens to support themselves, there is (and will be) simply no other alternative.
From time to time, investors’ moods might be characterized as optimistic. Frankly, optimism usually comes after stock prices have already risen for a while. To judge from historical experience, when stock prices continue to march higher, investors’ moods often improve from optimistic to excited. Then, if stock prices move yet higher, investors might become thrilled. And finally, if stock prices seem to soar even higher than anyone ever expected, investors frequently become euphoric. Following euphoria, however, market history tells us that stock prices often begin to decline. (After all, most everyone has already bought.) As stock prices move steadily lower and lower, investors’ moods usually evolve from euphoria to anxiety, denial, fear and then perhaps desperation. Even that’s not always enough pessimism to get the last of the emotional investors to sell, however. So then the going really gets tough. As prices continue to fall lower than anyone expected, investors’ moods swing to panic, capitulation and even depression. Many of our clients know what comes next. Stock prices begin to rise, of course! (Selling is exhausted.) Investors begin to see a few rays of hope, and then maybe they experience relief. Next comes optimism—and we’re back where we started. The point of this discussion, dear clients, is that extreme emotions are usually contrary indicators of future stock prices. In other words, successful investors need to buy when other investors are depressed and sell when they are euphoric. Although this is easy to state, it’s hard to do, even for some of the best investors.
If workers want to retire in comfort, they need to save adequately and invest wisely. It’s as simple as that, dear clients. How large a nest egg should one accumulate? That depends on a number of factors, such as living costs, the expected length of retirement, inflation, taxes and one’s investment rate of return. ... consider both 20-year and 30-year retirements. I assumed a 20% average tax rate on funds withdrawn from a retirement account, 3% inflation, 5% annual investment return and the expectation of drawing one’s nest egg down to zero at the end of retirement. While 5% is well below what we’ve achieved for our clients since our inception and well below what we expect to achieve going forward (past performance is no guarantee of future results), I think it’s a realistic estimate for most investors—given low interest rates, our outlook for about 6% annual returns for the S&P 500 over the next ten years, and given the typical investor’s actual results during the prosperous 1984 - 2002 period ... over a 20-year retirement, one’s starting nest egg would need to be approximately 21 times after-tax living expenses in the first year of retirement. Over a 30-year retirement, it was about 29 times. Soooo . . . a simplistic rule of thumb would be that, given our assumptions, one should accumulate a nest egg that is approximately equal to annual living expenses (to be supported by this nest egg) multiplied by the number of years one expects to be retired. Thus, if one has after-tax living expenses of $100,000, for example, then a reasonable goal would be to accumulate a $2 million or $3 million nest egg for a 20-year or 30-year retirement, respectively. (Of course, one’s retirement analysis should be updated regularly, especially if circumstances change.)
Bonds are usually less volatile than stocks and, therefore, some would say they are less risky. (If the risk in question is that of earning an inadequate return, however, one could make the point that bonds may be more risky than stocks.) Since investment return is, in part, the compensation that investors receive for shouldering volatility risk, it stands to reason that over the long run, bonds (being less volatile) should underperform stocks (which are more volatile).
…portfolio values are virtually always down from their peaks—that’s why they’re called peaks.
Over the long term, stock prices in the aggregate mirror the growth in the economy. Inflation aside, our economy grows mainly due to advancements in productivity brought on by advances in science and business methods, increases in the usage of capital equipment and progress in worker skills. These factors work only in one direction—growth. While shorter term economic and geopolitical cycles (recessions and cyclical expansions, war and peace) are common, they have never represented more than waves in an advancing tide. During good times investors tend to become overly optimistic and bid stock prices to unreasonable heights. These times are not the best to buy most stocks. During tougher times, investors frequently forget that all past recessions and wars have ended, and they allow their fears to lead to overly pessimistic views. Such times are when experienced investors sharpen their pencils. These are the investment facts of life...
In past client letters I’ve tried to shed some light on a number of economic and investment misperceptions. One persistent problem, as I see it, is investors’ tendency to regard the Dow Jones Industrials or the S&P 500 as “the market.” While many investors understand that there are only 30 stocks in the Dow, the 500 stocks in the S&P 500 seem to give it a flavor of much broader market representation. However, the S&P 500 is capitalization weighted, which means that each stock in this index has a weight equal to the stock’s capitalization (number of shares times the price per share) expressed as a percent of the total capitalization of all 500 companies. In addition to the S&P 500, a number of popular indexes, including the Nasdaq Composite and the Nasdaq 100, are also capitalization weighted. (The Nasdaq 100 is simply an index of the 100 largest companies traded on Nasdaq.) Given that the Nasdaq 100 companies represent the overwhelming majority of the market capitalization of all Nasdaq companies, the Nasdaq Composite and the Nasdaq 100 track exceedingly closely. The degree of concentration in the Nasdaq 100’s weighting is much greater than most investors would guess.
. . . there seems to be something about the mixture of logic and emotion in most investors’ heads that pretty consistently prevents investors from accepting the validity of the relationship between popularity and risk. Popular stocks (and bonds) are risky precisely because their popularity drives their prices upward to the point that they become risky. We cannot, dear clients, do the popular thing and still expect to earn above average investment returns. Conversely, unpopular investments are frequently not as risky as they may seem, because their lower prices often remove significant risk.
Experienced investors understand that stock market returns come with stock market volatility. If stocks weren’t as volatile as they are, stock returns wouldn’t be as high as they are. Indeed, more broadly put, investment return is the compensation investors receive for shouldering risk.
There are never more sellers than buyers, and vice versa. Every share of stock sold is bought. From an investor’s standpoint, the important issue is what price makes the buying and selling equalize. In general, apart from movements in corporate earnings (which seem downright glacial compared to the volatility of stock prices), stocks change hands at relatively lower prices when investors are pessimistic and at relatively higher prices when investors are optimistic. So, if we want to buy low and sell high, we will typically find ourselves buying in times of pessimism and selling in times of optimism. Investors who follow TV gurus and decide to temporarily hold cash when most people are worried (not wanting to invest until the economic, investment or geopolitical outlooks improve) invariably find themselves buying higher, not lower. Think about investing this way:
Question: When is the best time to buy? Answer: When prices are their lowest.
Question: When are prices their lowest? Answer: At the point of maximum pessimism.
Because investors were willing to throw many billions of dollars at the flimsiest of businesses (and mere business plans) during the late 1990s, lots of unproductive companies were founded and funded. These businesses built offices, bought equipment, borrowed money and hired people until investors finally cut off their funding after realizing how unprofitable these companies were. As these businesses now unwind, we should not be surprised to find unused offices, idle equipment, bad loans and unemployed people—until the economic resources acquired by these companies can find their way into productive enterprises. Necessary (and ultimately very beneficial) economic adjustments may take time, but if the history of capitalism is any guide, they will definitely occur. Further, because of the significant mobility of resources in the U.S., these adjustments will occur more rapidly in our country than in almost any other market economy. In investment terms, this process will penalize investors in uncompetitive businesses and reward investors perceptive enough to foresee and take advantage of the adjustment process.
As always, what really counts for long-term investors are long-term results.
The sooner the marketplace gets over bubble-mania, the sooner our economy will become more competitive and the sooner investments chosen on their economic merit will achieve higher returns. Fortunately for us, history and the weight of reason are squarely on the side of informed and patient investors—who can afford to view temporary irrational pessimism and optimism simply as opportunities to buy low and sell high.
. . . there are two main types—defined benefit plans and defined contribution plans. Defined benefit plans are the more traditional type wherein retiring employees are promised a given (monthly) benefit by their employers. The responsibility to fund these pension plans and to ensure that they are capable of fulfilling their obligations rests with the employer. Defined contribution plans (such as the now common 401k) place the responsibility of funding and investing squarely on the shoulders of the employee. As long as employees set aside an appropriate amount of their earnings and invest wisely, defined contribution plans have a number of advantages. They allow more freedom of choice (an employee with a terminal illness shouldn’t be forced to save for retirement, for example), and they allow employees who don’t stay at one employer long enough to qualify for (defined benefit) pensions to be able to take their retirement savings with them as they move from job to job. However, as William Bernstein recently observed in Barron’s, defined contribution plans are not working as envisioned by their supporters. Of primary importance, people are just not saving enough. Among employees who have funded a 401k, the average account contains barely over $40,000. Worse, many employees choose not to save for retirement at all. Further, employees as a group have proven to be poor investors—often being too conservative when they should be more aggressive and too aggressive when they should be more conservative. For many of today’s employees there is essentially no way that they will accumulate enough savings to have a meaningful impact on their retirement budgets. I’m not sure what will happen when millions of people with inadequate retirement savings start to retire, but I am fairly sure that you and I are not going to like it. If Social Security is a big disappointment (and I think it is), then the defined contribution plan concept may be an even bigger disappointment.
We have no idea—and never have had—whether the market is going to go up, down, or sideways in the near or intermediate term future. What we do know, however, is that occasional outbreaks of those two super-contagious diseases, fear and greed, will forever occur in the investment community. The timing of these epidemics will be unpredictable. And the market aberrations produced by them will be equally unpredictable, both as to duration and degree. Therefore, we never try to anticipate the arrival or departure of either disease. Our goal is more modest: We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.
…the correlation between movements in the S&P 500 and in the market of non-index stocks has become noticeably weaker in recent years. In one sense, the S&P 500 has become simply another managed portfolio (as opposed to an index of the overall market), with the management being supplied by Standard and Poor’s.
…our investment strategy is not—and never has been—dependent on perpetually smooth economic growth. We take the economy’s lumps as they present themselves, and we do our best to take advantage of the long-term opportunities created by volatility in the economy and in stock prices. While others may focus on nearby trees in the economic forest, we’ll be working extra hard to continue to focus on the forest itself.
Had we somehow known at the start of 2000 that the S&P 500 was going to decline approximately nine percent over that year, and had we decided to sit out the year waiting for more attractive prices, we would have missed out on the 25-30% gains we actually achieved in 2000.
Overpriced merchandise needs to be marked down to sell, and way overpriced merchandise needs to be marked down a lot. Given the incredible run-ups in a number of technology favorites in 1999 and early 2000, Nasdaq’s approximate 60% decline from its peak has produced precious few bargains in the high technology sector. In recent days tech stocks have bounced upward somewhat—a fairly normal occurrence after a steep drop. While it’s possible that the worst is over for tech stocks, I wouldn’t bet on it. The Nasdaq index has gone from being way, way overvalued (at 7-8 times its normal p/e ratio) to being highly valued (at 2-3 times the normal Nasdaq p/e). In any event, our success in investing is not predicated on timing the market. We’ll continue to actively research companies in various industries and to buy attractively priced stocks as we find them—just as we always have.
Over the next 10 years I think S&P 500 earnings will grow about 7-8% per year on average. To this number, I’d add about 2% per year for dividends and then subtract about 5% per year for p/e ratio contraction (back to more typical levels). In sum, I think the S&P 500 will average a return of only 4-5% annually over the next 10 years. Index investors need to deal with this outlook which, I submit, is realistic, not pessimistic.
We are neither small-cap managers nor large-cap managers. Rather, we have always aimed to be intelligent investors. We pursue investment bargains wherever we find them (to do otherwise would be truly foolish) and, like a veteran football quarterback, we aim to take advantage of whatever opportunities the environment presents. To date, we’ve found more opportunities among overlooked small and medium-sized companies, although we’ve managed to be extremely selective in choosing our investments. The fact that the Russell 2000 small-cap index was down in 2000, while we enjoyed 25+% gains speaks volumes in terms of not arbitrarily assigning J.V. Bruni and Company to the ‘small-cap’ box on some simplistic spreadsheet of investment managers.
In the final analysis, money managers operate within the bounds of what their clients allow. When some investors insisted that their portfolio managers chase faddish investments, our clients gave us the flexibility to acquire out-of-favor investments with an eye toward the future. As a result, during the indexing fad and high tech bubble we were able to acquire a number of stocks at very attractive prices, while other managers felt compelled to cater to their clients’ fashionable (and expensive) tastes. Your understanding and acceptance of our investment strategy has made it much easier to achieve the success we both seek.
To some people, growth investing simplistically means buying stocks that go up, whereas value investing means buying stocks that don’t—as if anyone would intentionally do that. To others, growth investing means buying stocks of companies that are growing operationally (or, better, have grown), and value investing means buying companies with nominally high assets on their balance sheets, but (usually) little ability to use these assets to create earnings. Things aren’t this simple, dear clients. Stocks that have grown in the past don’t always continue to grow (often, because they become overpriced and, thus, disconnected from reality), and faster growing companies almost always find that their high operational growth slows or ends. Further, high-valued assets that don’t eventually contribute to earnings really aren’t high-valued. In reality, there is only one type of investing that has consistently worked, and that is the process of buying investments when current prices do not adequately reflect current and future economic reality—a process that requires insight, careful research and patience. One can call this process anything (I prefer ‘classic value investing’), but the name isn’t that important. In reality, the simple ‘growth’ and ‘value’ terms are more marketing labels than descriptions of investment theories.
…very few people know who David Blitzer is and how influential his decisions are. Mr. Blitzer heads a committee at Standard and Poor’s that decides which stocks will be included in the S&P 500—thus essentially deciding how hundreds of billions in index fund and ‘closet’ index fund monies are invested…. It probably doesn’t occur to index fund investors that their investments help distort free market (capitalist) resource allocation, but that’s exactly what’s happening. Investment capital allocation based on factors such as profitability and business outlook has been replaced with allocation based on inclusion in an index. In addition, Mr. Blitzer’s S&P 500 selections help explain the lofty valuations in some technology stocks (given all the mandatory index fund buying) and the relatively lower market valuations of non-technology companies. Heaven help us if Blitzer feels a need to include underwater basket-weaving stocks in the S&P 500.
…sharp day-to-day swings in stock prices…are symptomatic of emotional, momentum-driven trading, since rational investors don’t change their long-term outlooks meaningfully from one day to the next.
Recently, a leading proponent of internet stocks predicted that 75% of all internet companies will fail, and then he recommended buying a basket of internet stocks—presumably increasing one’s odds of buying three times as many losers as winners… In short, like a heroin addict consuming ever-larger doses of heroin, the tech stock bubble appears to be burgeoning at an increasing rate. The sooner it ends, the sooner rational investments will shine again.
. . . investors risk opportunity losses by being out of stocks when they move upward.
If we were to write a script for obtaining above average returns, it would begin with an opportunity to acquire excellent investments at fire sale prices—presumably because other investors were otherwise preoccupied. Then, our script would call for the best bargains to gain recognition and to appreciate as investors refocused on the attractiveness of our investments. (In reality, this script has been played out a number of times in the past, bringing rewards to patient and perceptive investors.) The current investment environment looks as close to the bargain portion of this script as any I’ve seen in years. The recognition and appreciation portion may await the bursting of today’s narrow market bubble, so it shouldn’t surprise anyone that we’re listening intently for a ‘pop.’
All companies have a risk of operational disappointments (in revenues, earnings, etc.). In addition, all stocks have stock price risk—namely, the risk that the current stock price might be too high, regardless of a company’s future operational performance. Companies perceived by investors to have lower operational risk tend to have higher price risk, and companies with higher operational risk tend to have lower price risk. Contrarian investors, such as ourselves, see the prospects for better returns in the higher operational risk/lower price risk category and, therefore, we aren’t surprised when some of our companies disappoint operationally. Just as a successful football quarterback understands that despite his best efforts he may throw incomplete passes and even an occasional interception, we understand that operational disappointments are an inevitable part of investing.
Many investors simply follow their emotions and the investing herd. The popularity of jumping onto short-term trends explains why markets gyrate far more than economic reality. Remarkably, many investors follow the briefest of trends. . . . . Investors feel empowered by their ability to make low-cost transactions; so they buy and sell frequently without much appreciation of whether they’re increasing or decreasing their odds of success. . . . , in recent times marketplace prices have been determined in good part by investors whose trading has little to do with logical analysis and lots to do with emotional behavior.
Markets serve one simple function—they equalize (or ‘equilibrate’) supply and demand. Since every share bought must be sold (and vice versa), market prices swing however much is necessary to cause an equal amount of buying and selling.
…investment history tends to repeat itself, although not always in identical ways. The best investment buys are never obvious or popular when they’re the best buys. The same can be said of investment sales. Popular investment ideas (whether they represent optimism or pessimism) arrive, they become overemphasized by investors who think they’ve found a new secret to success, and then they fail—sometimes spectacularly. Supposedly smart people, thinking they’re being sophisticated, act foolishly and lose a lot of money. Politicians keep trying to impose their political will on economies and thereby manage to make matters worse. Novice investors want to buy low and sell high, but they are often swayed by popular sentiment to accomplish just the opposite. As easy as it is to see these recurring trends from a distance and with the benefit of time, it is much more difficult for investors to act with a long-term focus amidst short-term turmoil.
The ghosts of manias past should teach us a valuable lesson. That is, although multi-year manias […], supported by plausible-sounding arguments at the time, can drive prices to tremendous heights temporarily, chasing popular fads is ultimately a very risky and costly endeavor.
In addition to the swings of economic factors such as demand and supply, markets are affected by psychological swings, which tend to reinforce economic swings. When prices are declining, investors tend to want to sell investments (whether they be oil, stocks, bonds, mutual funds or whatever), and when prices are rising, investors tend to want to jump aboard. Thus, economic and psychological pendulums tend to swing together and, therefore, really move markets.
If a company has a good story, then its stock rises as investors bid up its price to reflect the story. Then, forgetting that the good story is already discounted/reflected in the current stock price, investors bid up the stock again—and again—on essentially the same information. Eventually, the company’s stock price bears little resemblance to economic reality and becomes poised to correct back to a sane level.
A similar [medley race] analysis applies to investing, where one’s long-term success depends on how well he or she navigates a number of different investment environments. For example, sometimes higher p/e ratio stocks do relatively better and sometimes lower p/e stocks outperform. Also, sometimes big company stocks perform better, and sometimes small company stocks have the advantage. While it would be nice to perform the best in all market environments, it’s essentially impossible to do so. Just as for Olympic athletes, the secret to success for investors is to build up a large lead in environments that are favorable to one’s (investment) style and to give up as little of that lead as possible in adverse environments.
If we wait until we see the whites of the eyes of better times [before we invest], it will be too late. The stock market typically moves well in advance of news stories.
I know what you’re thinking. Everything seems to remind me of economics or investing. I plead guilty, as charged. In all candor, I hope the day never comes when I stop seeing economic or investment parallels with much of everyday life, because if that happens it may well signal a loss of my enthusiasm for investing. In my observation, investing success usually results from an approach that is partly scientific and partly passion. If the passion goes, science alone isn’t enough to sustain one’s success. For the present, I hope our clients will patiently suffer my monthly climb onto my favorite soap box, from which almost everything looks like part of a giant economics and investment puzzle, and view it as an unavoidable side effect of my fascination with matters economic.
Whenever we attempt to lead markets, we have to deal with uncertainty. To the extent that any company’s outlook is predictable, that outlook is already priced into its stock. The way successful investors earn their keep is by anticipating future events before other investors do. Generally, if we wait until we see the whites of an investment’s eyes, it’s too late. We need to think beyond that which is clear at the moment, and in doing so we take risks. If our analysis is right, our investments will eventually re-price higher (sometimes much higher) as our expectations prove to be valid. Similarly, when the future develops differently than we expect (which will happen from time to time when we try to anticipate the future beyond current consensus expectations), our investments will fall. The key to success lies not in eliminating risk (which would eliminate winners as well as losers), but rather in taking wise risks.
Buying low and selling high is much harder than it seems because, for example, it requires an investor to distinguish between merely lower and truly, fundamentally low. Since 1987, US investors have become accustomed to buying almost automatically after dips in the market. Such ‘blind’ buying can be a mistake when the investor is unaware whether there is real value at the lower prices.
All the world’s countries suffer to some degree from stunted economic growth due to certain well intentioned, yet counterproductive legislation. Did you ever wonder why, if minimum wage laws worked as intended, someone hasn’t informed the starving nations of the world that they can reduce poverty with the stroke of a legislative pen ? Or why, if any form of government-decreed standard of living actually created that standard of living, countries like Bangladesh don’t pump out more noble legislation ? The same can be said of protectionism or, more broadly, government interference in economies. The simple reality is that standards of living are produced by people like you and me, not by government fiat, and the freer people are to produce, the more they produce.
Fast-forward to the late 1990s. Partially as a result of a booming interest in international investing, which was portrayed by some as a way to increase investors’ returns while lowering their risk, a lot of money poured into a number of developing nations’ markets. As in the US experience, much money chased real estate investments of dubious merit, local financial systems were unprepared for the changing economic and investment environments, government regulators were asleep or looking the other way, and favoritism and corruption (which is a more accepted form of commerce in some countries) were carried to new levels. The result ? Another financial crisis has blossomed. And it, too, was inevitable. Only its timing should have been a surprise.
We should consider buying or selling investments based on a detailed, impartial, careful review of the facts combined with an independent analysis and a review of our personal objectives, time frame and tolerance for both risk and volatility. Instead (and unfortunately), some investors find their enthusiasm for a given investment fluctuating with the investment’s price.
There’s a small army of consultants trying to convince investors that volatility is risk. It isn’t—at least, not for most investors. Some investors may decide that volatility is undesirable to the point that they want to take steps to reduce it, yet reducing volatility may not reduce risk. Risk, for most people, refers to the chance or likelihood that they will not achieve their financial goals. If an investor is planning to retire in X years and needs a certain-sized nest egg to support his retirement, then volatility in the context of achieving his goal will probably not seem so risky—especially when compared to less volatility in the context of not achieving his goal.
While some observers think of stocks mainly in terms of current prices or in terms of companies’ current earnings, dividends and cash flow, we can take a different tack. Since each share of stock entitles its owner to a fractional share of ownership of a company in perpetuity, I think it’s more realistic for us to consider companies’ results over many years. Even though we may logically weigh companies’ current year results more heavily than in any given future year, the fact that there are so many future years to consider means that much of what we should value in stocks relates to the future. I’d like to call the value that we place on stocks—when we view companies’ results over many years—the present value of forever.
The future of our economy and for intelligent investing is as bright now as ever. Bubbles always burst, and change is the successful investor’s best friend.
It is—or should be—obvious that any overly popular investment strategy will enjoy a period of exceptional performance as various “investors” convert to the strategy. Once the strategy is sufficiently popular and the number of followers peaks, the strategy’s superior returns will end. In time, the distortions and overvaluations caused by zealous adherence to any hot investment concept will be reversed. The larger the distortions, the longer and more painful the adjustment. The nifty-fifty, gold and Japanese manias were indeed substantial, and I don’t think indexing has reached their levels of nuttiness—yet. Every year we seem to be getting closer, though.
As investors, we should strive to remember how uncertain polls and surveys of investors can be. It remains a big mistake to base our investment decisions on what we think other investors think, even if the source of our information is The Wall Street Journal, NBC, CNN or whatever. I’m frankly amazed by the number of people who seem ready to jettison sound investment plans simply because they think they’ve read or heard an “authoritative” report to the contrary. (Of course, we’re thankful these people exist. They often buy what we sell and sell what we buy.) When it comes to investment and voting polls, please remember that voting polls are the more accurate.
Over the years I’ve taken issue with a number of popular investment ideas. One concept that I think the average investor understands much better than the supposed professionals is the concept of risk. It’s really quite simple: Risk is the chance (or probability) of not achieving one’s goals. If you’re saving for your retirement and you don’t accumulate enough purchasing power by the time you retire, then you haven’t reached your goal. If you are investing to preserve the purchasing power you already have and you buy stocks that decline, then once again you haven’t reached your goal. That’s risk.
Over the shorter term stocks are unpredictable and so present risk. Over the longer term inflation is all too predictable, and it presents the most meaningful risk. Simply put, risk is best expressed by the possibility of not achieving our goals rather than by some overused “beta” coefficient. Over the long term, stocks have overcome inflation risk much better than bonds…
Actually, I don’t worry a lot about market swings—although sometimes I worry that clients may be needlessly concerned. Frankly, I enjoy market declines because they usually give me an opportunity to take advantage of temporary bargains. For example, picture two ways the S&P 500 could be up 10 percent over the course of a year. One way would be for the S&P 500 to steadily climb at a 10 percent annualized rate. The other would be for this index to fall first and then climb to finish the year 10 percent higher than where it started. As far as I’m concerned, I prefer the second case because during the decline I should be able to take advantage of the swing so that we perform better—over the long run—than if the index had climbed steadily without a dip.
Many economists refer to inflation as a hidden tax, although I like to think of inflation as the “great equalizer.” When a society tries to pursue a national level of production beyond its production possibilities frontier by creating and spending money, price increases (inflation) deny that society the purchasing power benefits of the extra money—ensuring , as Flip Wilson might have said, “What you actually produce is what you get.”
For some time I’ve wanted to devote part of a client letter to a discussion of some of the factors that cause the short term volatility we see in financial markets—especially since these factors have changed so much in the last ten years . . . Until now, I’ve refrained from discussing short term swings for two reason. First, my investment approach is focused on long term analysis . . . The second reason I’ve avoided discussing short term swings is that the discussion can be a little technical. . . . Nevertheless, I think it’s time to give this a try—especially since I feel that a better understanding of short term volatility can make us better long term investors.
Indexing can be a reasonable strategy as long as its acceptance doesn’t change the underlying characteristics of the investing game. Unfortunately, it clearly does…When hundreds of billions of dollars are poured into just 500 investments, it’s logical to expect that the favored 500 are going to sell at higher prices than they otherwise would have commanded. I estimate that the S&P 500 stocks are 10-40% higher than they otherwise would be simply because of indiscriminate buying by indexers. As a result, the S&P 500 measure has been boosted by indexing, thus making it even more difficult for money managers and mutual funds to keep pace with this index. Of course, this has increased the pressure on investors to index—thus completing a vicious cycle. Such cycles don’t always end in an orderly way.
Every investment we make has certain risks. Since there’s no realistic way to eliminate all forms of risk, an assessment of an investment’s risk must be part of the decision to acquire it in the first place.
In any competitive endeavor it’s wise to study an opponent’s tendencies. In football, a given team may tend to run left on third-and-short situations, and in baseball a given pitcher may resort to his fastball when behind on the count. Similarly, it makes sense for us to know how other investors think and act. For example, it’s common for some investors to almost automatically buy a company’s stock when the company reports earnings above expectations and to sell if earnings are below expectations. (These are the so-called “momentum” investors.) While I doubt that this is the secret to long-term success, I do look for ways to exploit the short-term swings induced by momentum investing. Since short-term earnings expectations tend to be reasonably accurate (albeit sometimes rosy), even the best of companies will occasionally report slightly lower earnings than expected. When they do, it’s not uncommon for their stocks to be hammered temporarily. Of course, that’s when I might step in and buy—because long-term results are driven by long-term company performance, not what happens at the margin in any given quarter.
Our strategy is simple: We pursue top-rate investment performance in support of each client’s investment objectives through singularly independent and intensive research and analysis.
Benjamin Graham said it best when…he likened investing to having a volatile business partner this way: ‘Every day, Mr. Market—your partner in a private business—appears and names a price [for which] he will either buy your interest or sell you his. Even though the business that the two of you own may have economic characteristics that are stable, Mr. Market’s quotations will be anything but. For, sad to say, the poor fellow has incurable emotional problems. At times he feels euphoric and can see only the favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains. At other times he is depressed and can see nothing but trouble ahead for both the business and the world. On these occasions he will name a very low price, since he is terrified that you will unload your interest on him.
…when the degree of optimism in the market is essentially constant, prices tend to remain stable. When investors are converting their opinions from optimistic to pessimistic, prices fall because that’s the only way to maintain a balance between buying and selling as people lower their expectations. Similarly, markets rise when investors are converting from pessimism to optimism—not after they’re already fully optimistic. Thus, pessimism can be viewed as the fuel of a bull market—fuel that gradually gets used up as a market approaches its peak. Higher levels of pessimism simply translate into higher levels of fuel.
[In 1974], the market had just hit a bottom that it would never see again. Incredible bargains were everywhere. One could have thrown darts to select investments and still earned a small fortune in the coming years. Second only to the depths of the Great Depression market bottom, there were more investment bargains than at any other time in any of our lives. The opportunity of a lifetime lay just ahead, and what was the prevailing mood on Wall Street? Sheer gloom and doom. Almost everyone seemed resigned to the market going lower amid the depressing news of the day.
There are lessons in all this, dear clients. First, great buying opportunities go unheralded, and the news is always darkest at the bottom. Second, there is normally a believable bogeyman frightening investors (such as the fear of wage-and price controls…). Third, the reality of bargain prices doesn’t set in until well after the fact (and at significantly higher prices). Lastly, don’t look for investment guidance in The New York Times—or any other newspaper.
Since the number of shares sold on any given day on Wall Street exactly equal to the number shares bought, talk about there being “more buyers than sellers,” or vice versa, doesn’t make any sense. It’s not the numbers of buyers and sellers that cause share prices to change hands at higher or lower prices—it’s the attitudes of the buyers and sellers. When investors are optimistic, shares change hands at higher prices, and when they’re pessimistic, shares trade at lower prices. In short, the study of stock prices is essentially the study of the economic and psychological factors that affect investor attitudes.
Looking at the short run condition of today’s market, it’s more relevant that investors are currently pessimistic than why they are.
We can run, but we can’t hide from the eventual breaking of many government financial promises. Either future generations of working-age voters will catch on and vote to curtail government pensions, Social Security and Medicare spending, or we’ll likely try to fulfill unfulfillable promises by printing money much more rapidly—thereby subjecting ourselves to one of the greatest and most vicious of all taxes—inflation. Inflation, frankly, is the final medicine for voters who won’t take their economic remedies any other way.
I enjoy down markets. On one hand, since we’re going to have periodic declines, like them or not, we might as well be comfortable with them. More to the point, however, down markets create opportunities—sort of like a sale at your favorite store. The major difference is that store sales are advertised as buying opportunities, while sales in the markets are usually accompanied by scary headlines.
. . . a focus on short term economic fears and worries is fundamentally inconsistent with long term investment success.
Learning from history: The Dow Jones Industrial Average passed 1000, 2000 and 3000 [during the 1950s and 1960s]. Every time the market reached a new high, the “ignore-the-egg-on-my-face” pessimists seized whatever the news of the day was to spin yet another story of fear. (I’m not exaggerating about the emphasis that was continually placed on fearful news, and I invite my clients to visit their local libraries’ microfilm sections to review the newspaper stories that so dominated the popular press.) Let’s face it—fear sells!
With the benefit of the 20-20 hindsight that’s available to us now, I think we should consider some of history’s lessons. For starters, as we have seen, there will always be seemingly solid reasons to be fearful, and we can count on the popular press to keep them in front of our noses. Nevertheless, over the long run, economic growth (and, therefore, Dow Jones growth) has persisted, and the reason is precisely that growth is not dependent on the daily news or the fear du jour. The fact is, dear clients, that growth depends on science, technology, new business methods, work skills, and, in one word, productivity. In this regard, the evidence of time—back to the very beginning of human existence—is crystal clear. Neither wars, nor tyrants, nor plagues, nor the rise and fall of nations has stopped the development of human learning and progress. Indeed, if there has been one constant in history, it has been the progress of human development. It’s enough to make one…hopeful!
In discussing economic change, I think it’s important for us to realize that change sometimes causes negative side effects. Think about what Xerox did to carbon paper manufacturers, what IBM did to Underwood, what computers have done to typesetters, and so on. In all these cases, and many more, change was not good for everyone (at least, not in the short run), but on balance our society was better for these changes.
…our ability to identify and participate in long-term economic changes will be the most important factor in our long-run investment success. Rather than using our valuable time poring over the unpredictable short term, we’ll all benefit from a long-term attitude. There will be another bear market sometime and then another bull market, and the unpredictably-timed cycle will repeat. It isn’t realistic to believe we’ll be able to time the market’s overall movements, but it is quite realistic and important to invest with an eye toward benefitting from the steady diet of change our complex economy presents us.
Investment managers must always be reasonable and prudent people, sort of like the way we tend to picture accountants and clergymen. Prudence, in turn, tends to imply carefully following the consensus opinions of the time. However, in the investment business, prudence means a lot more. It often means looking ahead and investing in advance of the movements in conventional wisdom, and it means recognizing that what seems secured today may not be secure tomorrow. Similarly, it means making some investments that defy the common judgment of the time. Since no investor has a perfectly clear crystal ball, good investing amounts to careful analysis of the past, present, and probable future—with an important weight given to the future.
After many years working with hundreds of investors, I’m firmly convinced that [a correlation between investor personalities and investment success] exists! For example, skeptics don’t make very successful investors—at least not in my experience. Skeptics essentially won’t buy an investment unless it seems like a sure thing. The problem is that by the time a skeptic feels confident with a given investment, so does everyone else. By that time, all this confidence is built into a high stock price, and the investment isn’t a bargain. In fact, given the market’s history of extremes of optimism and pessimism, often times the skeptic’s purchases are over-priced. As a group, skeptics tend not to have a good grasp of the concept of risk…Successful investors have their share of home runs, but (like a good baseball player) they focus more on making solid investments (hits) than emotionally going for glory.
While it’s important to keep track of how our individual investments are doing, how our portfolio is doing, particularly over a full market cycle…it’s also important to understand why our performance is what it is. …It’s nice to enjoy strong performance, even if it’s caused by temporary Wall Street popularity, but it’s even better to know that our good performance is based on sound, long-term fundamentals.