THE STOCK MARKET DOESN’T GIVE OUT A “GENTLEMAN’S C”. MOST PEOPLE GET Bs AND Ds. OR WORSE.

AUTHOR'S NOTE: NOT SELF-AGGRANDIZE ONE'S SELF (ALTHOUGH THE AUTHOR WILL DO IT ANYWAY), BUT MANY OF THE AUTHOR'S OLDER POSTS STILL RECEIVE LOTS OF HITS. MANY ARE FROM PRESTIGIOUS INSTITUTIONS SUCH AS THE WORLD BANK, HARVARD, THE FEDERAL RESERVE BOARD, AND EVEN THE RICE UNIVERSITY AND THE WORLD BANK. NONE FROM THE IRS, AS YET. THE POST BEWLOW FROM OCTOBER OF 2005 STILL RECEIVES LOTS OF HITS. SO HERE IT IS, AND IT IS AS VALID TODAY AS IT WAS 2 1/2 YEARS AGO.

A post the other day discussed the Secular Bear Market and what this means for investor returns for the next 10-15 years. And it isn’t good. One of the Author’s favorite financial writers appears today in John Mauldin’s “Outside the Box”. [i] Mauldin’s column features Ed Easterling of Crestmont Research. Easterling has dissected the Secular Bear Market and the reasons that Secular Bear Markets follow Secular Bull Markets. This reasoning is fully described and documented in Easterling’s book, “Unexpected Returns: Understanding Secular Stock Market Cycles”. There is so much wisdom stuffed into Easterling’s article that today’s Desert of the Real post will focus on why the “Buy and Hold” strategy should be called the “Hold and Fold” strategy. Another post will address why returns over the next few years cannot approach the “average” stock market return.

EVERYTHING YOU HAVE BEEN TOLD ABOUT “BUY AND HOLD” INVESTING IS WRONG. OR AT LEAST WRONGLY APPLIED.

The “Buy and Hold” strategy developed from at least two sources and at least one financial industry reason. The sources discussed are the Modern Portfolio Theory and the Ibbotson studies. Neither is wrong, but wrongly applied. The financial industry reason is more rational (and venal). Selling prepackaged investment packages under the “buy and hold” shtick earns financial advisors and annuity salesmen more fees for less work. And very few investment advisors are competent or dedicated enough to build and actively manage portfolios.

Modern Portfolio Theory holds that by carefully selecting a portfolio investment, risks can be reduced to the lowest point possible. Investment analysts often talk about “Systemic” risk and “Non-Systemic” risk. Let’s break them out:

1. Systemic risk is the base-line risk that is inherent in the stock market. This risk cannot be eliminated or reduced. Markets go up, markets go down. This risk has been quantified. If you own stocks you must incur this risk. There is now way around because it is systemic, or endogenous[ii], to the system.

2. Non-Systemic risk is risk that is not inherent to this system. In the stock market context, non-systemic risk is the risk incurred from buying individual stocks. The risk you take on is related to the stocks you hold and separate from systemic risk.

Here is an example. Suppose a person thinks oil industry stocks will out perform the market next year. So the person buys only oil stocks for his portfolio. This exposes the person to both systemic risk (which is unavoidable) and non-systemic risk. This non-systemic risk is the risk that oil stocks may or may not outperform the overall stock market. If oil stocks do well, the non-systemic risk the investor took was rewarded.

However, if the scientific team of Dr. Julius Kelp and Dr. John Frink invent a cheap nuclear fusion reactor that fits in a glove box and can power a 737 airplane, oil (and oil stocks) will drop precipitously in value. The risk of something making oil less valuable is non-systemic, or exogenous[iii] risk. It is risk the oil investor took, but did not have to take. Had the oil stock investor bought a large stock market index fund or ETF, he would have eliminated much of the non-systemic risk and narrowed his risk to the system (overall stock market) risk.

GARBAGE IN, GARBAGE OUT. NOT EVEN ANY METHANE GAS.

Harry Markowitz first published his work on Modern Portfolio Theory in 1952. He advised readers of his work as follows:

“The process of selecting a portfolio may be divided into two stages. The first stage starts with observation and experience and ends with beliefs about the future performances of available securities. The second stage starts with the relevant beliefs about future performances and ends with the choice of the portfolio. This paper is concerned with the second stage."[iv]

Markowitz says that before you can even do the portfolio selection, you must start with accurate future performance figures. So if you are faced with a Secular Bear Market where major stock indexes are flat for years but plug in some Pollyannaish average return of 10.35, or 9%, your projected returns will be wildly exaggerated.

IF ONLY WE ALL LIVED IN LAKE WOBEGONE, WHERE ALL THE CHILDREN ARE ABOVE AVERAGE

The Ibottson Associates studies are widely cited in the investment industry. According to the Ibottson study, as quoted in the Easterling article, the long-term average return of the stock market is 10.4 %[v]. The data set for this study began with 1926. The problem with this average is virtually no one will get the average return. This is because your return depends mainly upon when you begin your investments. Invest at the trough at the end of a Secular Bear Market and your returns will be handsome. But throw your money in at the peak of a Secular Bull Market (like 2000) and the following Secular Bear Market will lay waste to your portfolio.

IF YOU ARE READING THIS YOU ARE WAY ABOVE AVERAGE IN THE DESERT OF THE REAL!


[i]http://www.investorsinsight.com/otb.aspx
[ii] “Endogenous” is one of those cool words that economists and biologists get to use to impress their friends and family. Endogenous means internal to the system. In a minute, The Author will get to use this cool word’s antonym.
[iii] Exogenous means from outside of the system.

[v] Such estimates were often cited in the aborted Social Security “privatization” plan that President Bush promoted. These average stock market return figures were cited by politicians and pundits with no real understanding of their implications for investing within defined periods of time. But in fairness to the “privatization proponents”, opponents would often incorrectly claim that investing in the stock market was nothing more than “gambling”. It is the Author’s belief that rather than privatize the individual accounts, social security funds should be invested in appropriate markets by professional money managers, just as pension funds are managed. But we can expect politicians to misstate the truth.
But worse than the political spinning, these average return figures are frequently cited by investment professionals with no understanding of how they relate to actual market performance in a defined time frame.