Wednesday, September 28, 2005


Most everyone has heard the aphorism that the value of real estate depends on location cubed. And many investors know that good investment results depend upon when you buy the asset and when you sell it. And while we intuitively know this, many of us fail at executing this most important requirement.

Rational investments are based upon predictions of future events. Investors buy stocks because they predict (or hope) that the price will go up. Conversely, some investors short stocks when they believe the price will go down. Simple enough. So what goes wrong with many investors and investments?

Economics addresses the allocation of scarce resources. If something is scarce and desired, it is valued higher than something that is plentiful and less desirable. Just compare a Faberge Egg to a boiled egg.

Consumers have a limited supply of money. As consumers, we seek to maximize the value of the expenditures we make. Simply put, we seek out bargains and try to get the best “deal”. When prices on a good are low, we buy more of a good or service. When prices are high, we buy less. [1] Common sense and human nature. It is also nature. Organisms, people, animals, plants, protozoa all seek to minimize the energy expended on an activity and maximize the value of the activity. Pick the low-hanging fruit.

But investment professionals observe that things often work the other way when people purchase investments. They tend to buy when things are high and sell when things are cheap. They get the worst of both worlds. They fail to understand or remember that markets are means-reverting mechanisms[2]. And you don’t need to take a statistics course to understand this concept. Jeremy Grantham, one of the top investment managers and financial minds in the world describes the means-reverting nature of capitalism in the following statement:

"Economic trends mean revert because there is a powerful and persistent normal return toward which capitalist competition strives, competing down handsome margins and P/Es and avoiding low returns until shortages develop."[3]

It cannot be more succinctly stated than this. If you buy a stock when it is “over-priced”, it will revert to its mean and fall in price. If you buy a stock when it is “under priced”, it will means revert and rise in price. Most readers should be saying, “Well, Freaking Duh, Motorcycle Boy!” But bear with the Author for a few sentences.

Price. Timing. Everything. Much of the content of the Author’s newsletter, “Welcome to the Desert of the Real-Real Investment Returns in a Dry Season,” addresses these issues and many of these posts will cover the same ground. So save the link to this site, come back often and tell your friends. And if you wish to receive back issues of the newsletter, or subscribe to new ones, send your email address. The newsletter is free of charge.

Don’t wear culottes in the Desert of the Real.

[1] This is true for most goods and services, as most goods and services are “Price Elastic”. Price elasticity refers to the tendency of the price of a good to fluctuate as demand and supply change. Some goods are very elastic. Watermelons, for instance. When prices of watermelons are low, people by more. When the price goes way up, sales go down. Watermelons are not necessary to maintain life and there are many substitutes for watermelons such as muskmelons (cantaloupes), honey dew melons, and other types of fruit. The price of emergency surgery for a gunshot wound is far less elastic. Of course this gets us into the area of healthcare economics, the economic area where the Author took his biggest academic plunge. He is still waterlogged from the experience.
[2] There are many issues involving investment and economic psychology involved also, but means reversion is always operating.
[3] “Letter to the Investment Committee IV”, p. 2, Jeremy Grantham is a principal at GMO, LLC in Boston, MA.