Friday, October 31, 2014

Quality Stocks & the Risk-Return Tradeoff

Roughly five years ago, Jeremy Grantham said the following about what he calls "quality stocks".

"Quality stocks have outperformed the market since 1965 (when our quality data begins)..."

When Grantham talks about "quality stocks", he is referring to those that produce a "high and stable return".

He then adds:

"...Fama and French adopted a circular argument rather typical of finance academics in the 1970 to 2000 era: the market is efficient; P/B and small cap outperform, ergo they must be risk factors. That the result in this case happens to get to the right result is luck. The real behavioral market is perfectly happy not rewarding 'risk' when it feels like it, as is shown by the 70-year underperformance of high beta stocks. But this time it worked. Price-to-book, despite its low beta, is a risk factor because of its low fundamental quality and its vulnerability to failure in a depression. This is true with small cap as well. But what about 'Quality?' This factor has outperformed forever. (The S&P had a High Grade Index that started in 1925 and handsomely outperformed the S&P 500 to the end of 1965 when our data starts.) Since the market is efficient, to Fama and French quality must be a risk factor! So, by protecting you in the 1929 Crash and in 2008, and by having a low beta for that matter, Quality as represented by Coca-Cola and Johnson & Johnson must be a hidden risk factor. Oh, I know: 'The real world is merely an inconvenient special case!'"

The bad news is, unlike when Grantham wrote the above, quality stocks aren't at all cheap these days. Still, the above makes an important broader point about risk and return even if the stocks themselves -- at current prices -- are far less attractive.*

So let's start by looking at a rather conventional explanation of the tradeoff between risk and return.

From Investopedia:

"...potential return rises with an increase in risk. Low levels of uncertainty (low-risk) are associated with low potential returns, whereas high levels of uncertainty (high-risk) are associated with high potential returns."

So many assume that more risk must be taken to produce greater rewards. That might at first glance seem very reasonable but, well, it's just not.

Brett Arends explains it this way:

"Conventional wisdom will often tell you that the only way to earn higher returns than the overall stock market — the only way to 'beat the market' — is to take more risk.

This idea is at the heart of the 'modern portfolio theory' that is probably practiced by your investment manager. It sounds plausible. It sounds credible. Everyone can understand it, and it is a generally accepted assumption.

The only problem? It's wrong. New research has found that you could have earned higher returns than the market in the past while taking on lower risk. This isn't a minor detail. This turns conventional finance upside-down."

Howard Marks put forward two useful and relevant charts on risk and return (at the bottom of page 6 of this memo). The first presents risk and return the traditional way (with risk and return positively correlated).

The second chart explains the relationship between risk and reward in a way that, to me, much more closely represents the world as it is.

Here's how Howard Marks explains it:

"We hear it all the time: 'Riskier investments produce higher returns' and 'If you want to make more money, take more risk.'

Both of these formulations are terrible. In brief, if riskier investments could be counted on to produce higher returns, they wouldn't be riskier."

Howard Marks on Risk

So risk and return need not be positively correlated.

It's simple, important, and too often ignored.

In the past I've referred to the following quote from the Superinvestors of Graham-and-Doddsville but it's worth repeating here:**

"Sometimes risk and reward are correlated in a positive fashion. If someone were to say to me, 'I have here a six-shooter and I have slipped one cartridge into it. Why don't you just spin it and pull it once? If you survive, I will give you $1 million.' I would decline -- perhaps stating that $1 million is not enough. Then he might offer me $5 million to pull the trigger twice -- now that would be a positive correlation between risk and reward!

The exact opposite is true with value investing. If you buy a dollar bill for 60 cents, it's riskier than if you buy a dollar bill for 40 cents, but the expectation of reward is greater in the latter case. The greater the potential for reward in the value portfolio, the less risk there is."

The math is obviously pretty simple but let's quickly walk through this:

A dollar bill is found on the ground by two people.

It's probably real.

It might not be.

One person is willing to pay 60 cent (i.e. less than the face value because, if not real, it might be worth zero).

The second is willing to pay 40 cents.

Well, the first person can make 67% if the dollar bill is real and, of course, can lose the 60 cents if it's a fake.

The second person can make 150%, if real, and lose the 40 cents, if not.

Two-thirds the possible loss; more than twice the return. Reduced risk of permanent capital loss; greater reward. Things like the capital asset pricing model (CAPM) and the three factor model are not built for the possibility of a negative correlation between risk and reward. So the higher return produced at less risk ends up as alpha. Well, at least it does for those who buy into modern finance theory.

To me, this makes alpha the ultimate fudge factor because, in a scenario like the above, it masks what's really going on.

It masks the reality that, sometimes, risk and reward need not be positively correlated. This might seem harmless but I think the relationship between risk and reward as it is (whether positive or negative) should be explained in clear terms (i.e. instead of calling it an abnormal rate of return compared to what's predicted by an equilibrium model like CAPM).

So the assumption more risk must be taken to get more reward is an incorrect one. This idea is not exactly new -- considering that Buffett's comments, for example, were made roughly 30 years ago -- even if frequently ignored.

Somehow, that more risk must be taken to increase rewards remains at the core of modern finance to this day.


Related posts:
-Howard Marks on Risk
-Altria: Timing Isn't Everything, Part II
-Altria: Timing Isn't Everything
-Grantham on Efficient Markets, Bubbles, and Ignoble Prizes
-Efficient Markets - Part II
-Risk and Reward Revisited
-Boring Stocks
-Efficient Markets
-Modern Portfolio Theory, Efficient Markets, and the Flat Earth Revisited
-Buffett on Risk and Reward
-Buffett: Why Stocks Beat Bonds
-Beta, Risk, & the Inconvenient Real World Special Case
-Howard Marks: The Two Main Risks in the Investment World
-Black-Scholes and the Flat Earth Society
-Buffett: Indebted to Academics
-Friends & Romans
-Superinvestors: Galileo vs The Flat Earth
-Max Planck: Resistance of the Human Mind
-Defensive Stocks?

* The higher quality stocks mostly are not selling at a discount to value these days. At least that is my view. They're still good businesses but the shares just don't provide any protection against what might go wrong. It's, of course, impossible to predict when shares are going to sell at attractive prices. The risk of not owning a good stock at a fair price is a real one (error of omission) that sometimes doesn't get enough consideration. It's why buying what becomes cheap (for those comfortable buying individual stocks) when the opportunity arise is so important. It wasn't tough to buy shares in some of the highest quality businesses at a nice discount to per share intrinsic value several years ago. The situation is very different now. Unfortunately, it's just not possible to know if/when they'll be available at a discount in the future. So decisive action with an eye toward the long-term (i.e. that means mostly ignoring the near-term and even intermediate-term price action after purchase) is required whenever they happen to get cheap enough. The time to buy with a big margin of safety, at least for now, seems to have passed.
** See toward the end of the Superinvestors of Graham-and-Doddsville for more on risk and reward and why it need not be correlated in a positive manner. That more risk must be taken to achieve greater rewards, along with efficient markets and rational expectations, still somehow take center stage within much modern finance theory. They remain at the heart of modern financial and economic theory though, fortunately, some of these theories have taken a real hit. Their influence over time -- sometimes quietly, sometimes less so -- can do real world economic damage.
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Friday, October 24, 2014

Buffett on Investing Mistakes

There have been plenty of headlines lately about things not going Warren Buffett's way -- at least in the short-term -- with some of his investments.

As long time owners and followers of Berkshire Hathaway (BRKa) know well, Buffett over the years has gone out of his way -- usually in the annual letters -- to point out when he makes a misjudgment that ends up costing Berkshire investors. Some of these -- though not necessarily all -- will prove to be just the latest examples. That investing mistakes will be made is close to inevitable even for those who are very good at it. From the 2013 Berkshire Hathaway shareholder letter:

"It's vital, however, that we recognize the perimeter of our 'circle of competence' and stay well inside of it. Even then, we will make some mistakes, both with stocks and businesses."

IBM's (IBM) stock -- one of Berkshire's bigger equity holdings -- recently took a particularly significant hit. The company's stock fell as a result of disappointing near-term results and the outlook. It's, in fact, now selling a bit below the price that Buffett paid a few years back. Time will tell whether the investment wasn't a good one for Berkshire. I'm sure some will conclude that, based upon the price action, the market has spoken and therefore it has not been a good investment. What will really matter, as Buffett explained in the 2011 letter, is this:

"In the end, the success of our IBM investment will be determined primarily by its future earnings. But an important secondary factor will be how many shares the company purchases with the substantial sums it is likely to devote to this activity."

Maybe IBM will prove to be a case of Buffett stepping outside of his 'circle'. I'm not convinced of that just yet but it's certainly possible.

IBM's recent challenges in meeting near-term expectations does cast at least some doubt on IBM's future earning power. So far it's hardly catastrophic but we'll see how it develops over time. The company, though it faces real challenges, still has far better core economics today compared to a decade or so ago. What they've done in that regard has been no small achievement. Revenue growth has been and likely will continue to be nonexistent. Yet IBM's return on capital has been improved substantially over the years. In the end, it's returns on capital and the price paid compared to intrinsic business value that mostly dictates future risk and reward. Revenue growth -- as long as it's high return variety -- can certainly be a good thing. It's just not necessarily a good thing. The problem is that some act as if, unless there is revenue growth, the results must be some form of financial engineering. Well, revenue growth for it's own sake may serve the speculator but doesn't serve the long-term owner. Some companies undoubtedly do engage in what appear to be questionable financial practices but, as far as I can tell, IBM does not seem like one of them. Now, I've written on prior occasions that -- and it continues to be the case -- I'm not a big fan of owning shares of technology businesses unless they are very inexpensive. Even then I'll, in general, only own certain tech stocks in small amounts.

Of course, some could fairly argue that IBM has already been a mistake.

It might just prove to be.

To me, it's a mistake if per share intrinsic value drops in a meaningful and permanent way*; it's a mistake if an unsatisfactory return is generated compared to understood alternatives; it's also a mistake if risks were taken that were poorly understood even if the investment happens to work out. For the long-term investor, the fact that the stock is currently higher or lower than the purchase price has nothing to do with this assessment. In fact, a stock falling stock even further below intrinsic value can be an unqualified advantage for the long-term owner if the business itself remains sound. Stock price action often fluctuates far more wildly than per share intrinsic business value. Lets say, for example, when quarterly results -- or even several quarterly results -- turn out to be disappointing.

Check out some of the recent headlines:

Warren Buffett just lost about $ 1 billion on this

Warren Buffett just lost ANOTHER $1B on this

Warren Buffett loses $2.5 billion in three days on Coca-Cola and IBM

Those headlines might just be more a reflection of an ethos that focuses on near-term price action and the speculative renting of stocks -- even if based upon fundamentals -- instead of ownership with an eye towards intrinsic values.

In each case the billions of dollars "lost" simply hasn't been lost unless Buffett needs to sell or the fundamentals have changed such that real intrinsic value has been or will be destroyed.
(It would end up being a loss, for example, if he required the funds near-term to buy an alternative investment that's more attractive -- opportunity costs.)

I'm definitely NOT a huge fan of IBM. It's a business that's constantly dealing with change. Far from the ideal investment. The stock may in fact turn out to be a subpar investment or worse. It's just not yet clear, at least to me, that the longer term investment outcomes will be unfavorable despite the real current difficulties. Even good businesses experience challenges from time to time and one usually doesn't get a chance to buy something sensible (for the long-term) at a nice discount when the near-term outlook seems rosy. IBM's stock may in fact underperform for some time, but the long-term oriented owner should be hoping for this so the buybacks can more effective.

Otherwise, the price paid along with how the business performs will ultimately have the most influence over long-term results. For investors that pay a fair (or better than fair) price, what's likely to happen to per share intrinsic value over long time frames, considering the risks and in comparison to well understood alternatives, is what really matters.

It's not about quarterly results.

It's absolutely not about what the stock does in the next few days, weeks, or even years.

It will be interesting to see what Buffett has to say about IBM at some point down the road. Maybe he's already concluded that buying IBM's stock wasn't a brilliant move on his part. If history is any guide he will make it clear if and when he considers it a mistake.

My own expectation is that IBM's specific challenges aren't going away anytime soon. Still, while IBM is not exactly my favorite business in the world, I do still plan to maintain a small long position.**

Errors of commission, where it's rather obvious what went wrong and how costly it ended up being, aren't necessarily the biggest problem for investors. Buffett has in the past emphasized the very costly, less explicit, but sometimes at least as important errors of omission. In recent years I've probably made too few errors of commission but too many errors of omission.***

Too few errors of commission may seem like an odd self-criticism but, in attempting to avoid possible losses, I sometimes end up not owning (or owning too little) of something sensible (when it was cheap enough to buy). So the too few errors of commission directly relates to making too many errors of omission. The power of loss aversion no doubt contributes to this. The risk that shares at a particular point in time sell at a reasonable discount to value might soon get too expensive to buy is a real one. Think about how many good businesses had shares that were selling at substantial discounts to value not all that long ago. The situation is very different these days.The avoidance of permanent loss should, of course, be the top priority. The tough part is not allowing that prime objective to get in the way of doing something sensible when the opportunity presents itself. It's easy to focus too much on the possibility of loss and not enough on well understood missed opportunities.

Investing always comes down to working within one's own limits. I don't doubt for a minute that others do a better job finding a good balance.

So the more explicit mistakes -- those of commission -- are not necessarily the most costly. There have been many times where I own a small amount of something when I should own a lot. It's a weakness that I've attempted to fix but, while some progress has been made, it's rather amazing how often I still end up owning too few shares of a business that I like and think I understand well.

It's worth pointing out that I'm not talking about missing the next transformational business. If I don't buy the next Facebook (FB) that's not a mistake even if it proves to produce a brilliant investment outcome. I'll almost always miss those kind of opportunities and I'm fine with it. That sort of thing is almost always going to be well outside my own "circle of competence". If I don't know how to value a business (within a narrow enough range), and it can't be bought at a nice discount to that estimate, the right move is to avoid.

Some might choose to focus on investments that went right and gloss over those that did not.

Successful investing requires a serious assessment of what didn't go right and why.

I'd add that few of us are able to understand how to value lots of different businesses.

"If you are really a value investor and do deep research, how many investments can you be involved in at the same time? If you are a high-frequency trader, you could trade 100 securities today. The real value investors are lucky if they can do 10 investments at a time." - Marty Whitman in this Barron's Interview

For me, it's important to stick to what I understand and, more importantly, knowing what I don't really understand. Maybe others can truly understand hundreds of different stocks but I'm more than a bit skeptical of this.

Some commentators seem willing to offer opinions on just about every investment alternative that comes up. Well, if someone has an opinion on just about every investment that's out there, it's probably going to be tough to figure which ones they truly understand.

I'm always impressed when someone responds with something along the lines of "I don't know".


Established a long position in BRKb at much lower than recent market prices; small long position in IBM established at slightly higher than recent market prices.

Related posts:
Buffett's Purchase of IBM Revisited
Why Buffett Wants IBM's Shares "To Languish"
Buffett on IBM: Berkshire Buys Big Blue
Technology Stocks

* IBM should earn ~ $ 16 per share this year. The company earned $ 11.52 per share in 2010 and $ 4.93 per share in 2004. That's certainly not a bad decade of performance for a larger company. The question is, of course, what will happen in the future. Maybe IBM's earnings are about to meaningfully decline. Does what happened this past decade say much about what's in store going forward? It may not. There's certainly no guarantee that the current earnings power will be persistent. That's only one of the many important judgments -- some easily quantifiable, many that are not -- any investor has to make.

** My position in the stock would change if the core business economics were to become materially altered, prospects have been misjudged by me (more likely to happen with IBM than some of my other investments), or maybe if opportunity costs come into play. If it does end up working out okay as an investment, it's going to be over a rather long time horizon. In fact, I won't be surprised if IBM's stock continues to disappoint for quite a while. In other words, those who like to profit from near-term price action will likely, and understandably, not find much use for it. The speculator naturally has a very different set of priorities.
*** Some focus on the risk of temporary loss but forget to consider the risk of losing the chance to own something sensible when it becomes available at an attractive price.
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Friday, October 17, 2014

John Bogle's "Relentless Rules of Humble Arithmetic", Part II

Back in 2007 at NYU, John Bogle talked what he calls his "second relentless rule of humble arithmetic."

During his remarks he said that: "Successful investing is not about the stock market, but about owning all of America's businesses and reaping the huge rewards provided by the dividends and earnings growth of our nation's—and, for that matter, our world's—corporations. For in the very long run, it is how businesses actually perform that determines the return on our invested capital. Dividend yields, plus earnings growth, account for substantially 100 percent of the return on stocks."

Here's a post on the first rule.

Bogle then references -- with the wording only slightly altered -- something that Warren Buffett once wrote.

Bogle's version:

"The most that owners in the aggregate can earn between now and Judgment Day is what their business in the aggregate earns..."*

Bogle calls this "the central reality of investing" then goes on to also mention the following from Buffett:

"When the stock temporarily overperforms or underperforms the business, a limited number of shareholders—either sellers or buyers—receive outsized benefits at the expense of those they trade with."

A whole lot of time and energy goes into trying to gain at the expense of other market participants when the focus really should be on what the businesses themselves produce in value over time. Bogle adds:

"How often investors lose sight of that eternal principle!"

Consider this as many expend lots of effort -- while incurring lots of frictional costs -- attempting to speculate on where the stock prices might be going in the near-term. If the emphasis was instead on the cash an asset can produce over a longer time frame (i.e. the fundamentals that determine intrinsic value) many participants would likely end up better off.**

More from Bogle:

"History, if only we would take the trouble to look at it, reveals the remarkable, if essential, linkage between the cumulative long-term returns earned by business—the annual dividend yield plus the annual rate of earnings growth—and the cumulative returns earned by the U.S. stock market. Think about that certainty for a moment. Can you see that it is simple common sense?

Need proof? Just look at the record since the twentieth century began. The average annual total return on stocks was 9.6 percent, virtually identical to the investment return of 9.5 percent—4.5 percent from dividend yield and 5 percent from earnings growth. That tiny difference of 0.1 percent per year arose from what I call speculative return, depending on how one looks at it. Perhaps it is merely statistical noise, or perhaps it reflects a generally upward long-term trend in stock valuations, a willingness of investors to pay higher prices for each dollar of earnings at the end of the period than at the beginning."

I personally never have any idea what the stock market is going to do nor do I even spend a moment thinking about it. The same goes for macroeconomic factors. Will the market drop dramatically? Will it rally? How will the global economy perform in the next 12 months? The only thing I feel reasonably comfortable with when it comes to prognostication is that's it's usually wise to ignore the prognosticators.

That's why I've not once attempted to forecast or predict anything. The good news is that a sound investment approach doesn't require such forecasting abilities. Lately, the markets have fluctuated a bit more intensely and, as a result, the investing world probably seems to have become more unpredictable, uncertain, and risky. I say "seems" because the future is always unpredictable and uncertain. It's merely the perception of that unpredictability and uncertainty that changes.

No doubt many will continue to try and figure out how the economic outlook might be changing and what the markets will do next despite the futility of doing so.

I think Morgan Housel recently made this point very well:

"The four most important words in investing are probably, 'I have no idea.'

I have no idea what the market will do next.

I have no idea if we'll have a recession this year.

I have no idea when interest rates will rise.

I have no idea what the Fed will do next.

Neither do you.

The sooner you admit that, the better."

Charlie Munger once explained it this way:

"Our system is to swim as competently as we can and sometimes the tide will be with us and sometimes it will be against us. But by and large we don't much bother with trying to predict the tides because we plan to play the game for a long time.

I recommend to all of you exactly the same attitude.

It's kind of a snare and a delusion to outguess macroeconomic cycles...very few people do it successfully and some of them do it by accident. When the game is that tough, why not adopt the other system of swimming as competently as you can and figuring that over a long life you'll have your share of good tides and bad tides?"

Some act as if they can read the macroeconomic tea leaves and reliably make effective investing decisions based upon that reading. Others seem to think it's possible to guess what the markets are going to do in the near-term in a way that will produce attractive overall results (their emphasis is on price action). Of course, it's certainly possible that some participants actually get good results this way. Yet I suspect that those who actually pull it off is a very small number compared to those who attempt to do so.

The good news is that judging macroeconomic factors, and guessing what the markets are going to do near-term, isn't what really matters for those of us who invest with the long-term in mind. What matters is whether you can judge the value of a business and buy it cheap enough so there is enough protection against what might go wrong.
(In many cases the worst possible outcome is unacceptable -- or too difficult to understand -- making avoidance of an investment altogether the right course of action. In other words, no price is low enough.)

Let's say the equity markets do eventually fall dramatically from current levels.***

Well, then the shares of some great businesses should temporarily become much cheaper to buy.

How's that a bad thing unless selling is required in the near-term?

Prices fluctuate far more than intrinsic business values, and reduced prices become an ally when someone is justifiably confident in their estimate of value.

A sound investment process should include the disciplined pursuit of the largest possible margin of safety. Generally speaking, if market participants become unusually concerned about future prospects then the likelihood of finding shares at a big discount to value will increase.

The cheaper the better as long as the intrinsic business qualities have been mostly judged well. It's, in part, learning to ignore the quoted prices of what's owned for the long-term and, instead, focusing on what can be bought at attractive prices. That means being ready to act when others are less inclined to do so.

There may be no way to eliminate investing mistakes but, via things like margin of safety and an awareness of limits, there are ways to reduce the quantity and costliness of those mistakes.

Focus on what businesses can produce in cash over time -- and, as a result, what they're intrinsically worth -- instead of how shares might be trading day to day.


Related posts:
Index Fund Investing Revisited
Charlie Munger on Complexity, Hedge Funds, and Pension Funds
Why Do So Many Investors Underperform?
When Mutual Funds Outperform Their Investors
John Bogle's "Relentless Rules of Humble Arithmetic"
Investor Overconfidence Revisited
Newton's Fourth Law
Investor Overconfidence
Chasing "Rearview-Mirror Performance"
Index Fund Investing
Investors Are Often Their Own Worst Enemies, Part II
Investors Are Often Their Own Worst Enemies
The Illusion of Skill
Buffett's Bet Against Hedge Funds, Part II
Buffett's Bet Against Hedge Funds
The Illusion of Control
Charlie Munger on LTCM & Overconfidence
"Nothing But Costs"
When Genius Failed...Again

* Warren Buffett, earlier this year, said something very similar in a CNBC interview: " the end, a stock today is worth all of the cash you can distribute between now and Judgment Day."
** With the vast majority of participants underperforming the markets as a whole -- despite all the unnecessary effort -- this seems rather evident. Too often investors do end up being their own worst enemy. Unfortunately, it's the thinking that it's possible to be in and out of positions at the right time -- with the idea of improving investment results, of course - that gets investors in trouble.
*** A near certainty but, practically speaking, attempts to figure out when the market will decline should be viewed as distraction and, again, an exercise in futility.
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Friday, October 10, 2014

Index Fund Investing Revisited

From the 2006 Berkshire Hathaway (BRKashareholder meeting:

Warren Buffett: If your pipes leak, you should call a plumber. Most professions add value beyond what the average person can do for themselves. But in aggregate, the investment profession does not do this – despite $140 billion in total annual compensation. It's hard to think of another business like that. Can you, Charlie?

Charlie Munger: I can't think of any.

How many years would a novice need to study and practice to be able to perform at a higher level than 80% to 90% of doctors?

I'm guessing most of us would have to study and practice for a very long time just to become reasonably competent (never mind top-tier).

For most other professions the answer will be not be much different.

How many years would a novice have to study and practice to be able to perform at a higher level than 80% to 90% of market participants, including the professionals?

Well, none as long as they stay away from trying to actively trade -- both individual stocks and funds -- and this includes, at least in a lot of cases, relying on others to actively manage their money.

When the pipes are a competent plumber. The expertise is likely to be well worth it.

In contrast...

"The statistical evidence proving that stock index funds outperform between 80% and 90% of actively managed equity funds is so overwhelming that it takes enormously expensive advertising campaigns to obscure the truth from investors." - From The Motley Fool

"Most people think they can find managers who can outperform, but most people are wrong. I will say that 85 percent to 90 percent of managers fail to match their benchmarks. Because managers have fees and incur transaction costs, you know that in the aggregate they are deleting value." - Jack Meyer, former head of Harvard's endowment, commenting on investment managers

So what's the right way to fix a portfolio that has underperformed?

Those that buy index funds consistently over time -- and learn to ignore near-term price action -- are in fact likely to perform better long-term than most market participants. There's enough evidence out there to more than suggest that the index fund, with basically little or no skill required, can actually move someone toward top-tier in terms of long-term investment performance. (Top-tier in terms of relative performance but, depending on overall market valuation levels, maybe not absolutely all that great.) It's at least a bit odd that some would consider only matching the market's performance somehow unsatisfactory when that result is better than 80% or 90% of active managers.

Too often investors do end up being their own worst enemy.

Unfortunately, it's the thinking that it's possible to be in and out of positions at the right time -- with the idea of improving investment results, of course -  that gets investors in trouble.

So, while there's realistically no way to perform better than vast majority of doctors (or plumbers) without the appropriate skills, knowledge, and experience, the index fund offers a rather straightforward way to perform better -- or, at least, increase the likelihood of performing better long-term -- than the vast majority of market participants including the professionals.

Yet, despite this reality, too many market participants will still try to beat the markets. One of the reasons for this is that investors tend to overestimate their own performance. A study of investors showed that they overestimated "their returns by more than 11 percentage points per year. The average investor painfully lags an index fund and thinks he's Warren Buffett, basically." 

I'm sure many think that overestimating investment results is what someone else tends to do; that it must be someone else's problem.


Professor Terrance Odean said that even when investors "are not better than average, they pretty much have to believe they are just in order to do what they are doing, to be active investors."

The tough part is remaining aware of what is an "observation bias, where people see themselves differently than they really are."

Some will overestimate their own performance to justify the effort when they could have just bought an index fund and focused their energy on something more productive.

Brett Arends recently offered why index funds often make so much sense for investors. It's certainly not because he thinks the markets are somehow efficient (nor do I). Here's how he explains it:

"I believe the market can be wrong, even wildly wrong, for long periods—and often is. So I don't believe a portfolio of random stocks or index funds is necessarily the best investment solution. But it’s pretty good if done right. It involves low costs, and immunizes you from the emotional challenges of investing. And it's especially good for big institutions, as it avoids most value-destroying limitations and complications."

Most investors will not outperform, for example, the Dow Jones Industrial Average. I bring up this particular index for a reason. It's the use of the word "average". An index fund might merely guarantee that the investor will match the market, but, maybe the word "average" in this context is what helps create the wrong impression. It may be a market average, but it hardly represents an average performance when compared to the results of all participants.

So matching a market average isn't the same as getting an average outcome. In fact, it's probably better to not think of a market index as an average at all. It implies a result that's in the middle of a normal distribution when the actual outcome is much better than that.

"By periodically investing in an index fund..... the know-nothing investor can actually out-perform most investment professionals. Paradoxically, when 'dumb' money acknowledges its limitations, it ceases to be dumb.

On the other hand, if you are a know-something investor, able to understand business economics and to find five to ten sensibly-priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you." - Warren Buffett in the 1993 Berkshire Hathaway Shareholder Letter

The right kind of temperament certainly helps:

"A lot of people with high IQs are terrible investors because they've got terrible temperaments. And that is why we say that having a certain kind of temperament is more important than brains. You need to keep raw irrational emotion under control. You need patience and discipline and an ability to take losses and adversity without going crazy. You need an ability to not be driven crazy by extreme success." - Charlie Munger in Kiplinger's

Outside of investment management there's no "index fund" equivalent that enables a novice to match -- never mind exceed -- the performance of most professionals.

Investment management is unique in this way.

Far too many who could benefit from this reality end up not doing so.

The bad news is that market valuations have become a whole lot higher in recent years. So that naturally means it's tougher to buy with a sufficient margin of safety. Unfortunately, some will get interested in buying stocks (or a fund) just when they're not nearly as attractive to buy. Successfully timing the market is easier said than done. That reality doesn't make understanding how prevailing market prices compares to per share intrinsic value irrelevant. Attempting to time the market is a waste of energy. Attempting to understand how price compares to value is not. For those who don't feel comfortable with judging value, consistently buying an index over time ends up being more than a reasonable alternative. Unfortunately, history suggests the pattern will often end up being increased buying during the good times (i.e. when stocks are usually more expensive) and selling during the not so good times (i.e. when stocks are usually cheap).

That's a tough way to get results.

At a minimum, considering the current valuations of many stocks, the expectations of future returns need to be much reduced. At least that's the case until the next bear market. 

In other words, the next inevitable bear market should be thought of as the long-term investors best ally.

"You make most of your money in a bear market, you just don't realize it at the time." - Shelby Davis

Ben Graham long ago said that investors should consider themselves "enviably fortunate" the next time a long bear market occurs. For someone with a long time horizon -- let's say 20 years or longer -- lower market prices in the near-term are a very good thing. Buybacks become more effective. More shares can be accumulated at a bigger discount over time. A severely down market is only a bad thing when someone has put money at risk in the equity markets and needs the money now.* 

Well, short-term money shouldn't be in the equity markets in the first place.

Attempting to predict when the next bear market will occur is folly. Just remember that bear markets are not at all a bad thing if the investment time horizon is long enough.

Of course, there are many capable individual investors who buy individual stocks and perform very well.

It's just that an investor with the right temperament and an awareness of limits can do just fine lacking the necessary investment skills, knowledge, and experience using index funds. This just doesn't exist for other professions. To me, it's not just the novice investor who should carefully give this consideration. More than a few investment professionals, at least based upon the number who underperform, would be wise to do the same.
(Even if, realistically, justifying and earning fees is a big factor.)

Many will no doubt continue to invest (or, worse yet, actively trade) in individual stocks in an attempt to outperform the markets. The temptation will prove irresistible for some and will likely be, at least for most of them, not necessarily very fattening in a financial sense. Naturally, some are and will be very successful buying individual stocks. Yet, with so many underperforming the market as a whole, more obviously think they are good at balancing investment risk and reward than actually are good at it.

This is why temperament and a realistic assessment of one's own limits comes into play.

Overconfidence is very expensive.


Long position in BRKb established at much lower than recent prices

Related posts:
Charlie Munger on Complexity, Hedge Funds, and Pension Funds
Why Do So Many Investors Underperform?
When Mutual Funds Outperform Their Investors
John Bogle's "Relentless Rules of Humble Arithmetic"
Investor Overconfidence Revisited
Newton's Fourth Law
Investor Overconfidence
Charlie Munger: Focus Investing and Fuzzy Concepts
Chasing "Rearview-Mirror Performance"
Index Fund Investing
Investors Are Often Their Own Worst Enemies, Part II
Investors Are Often Their Own Worst Enemies
The Illusion of Skill
Buffett's Bet Against Hedge Funds, Part II
Buffett's Bet Against Hedge Funds
The Illusion of Control
Charlie Munger on LTCM & Overconfidence
"Nothing But Costs"
When Genius Failed...Again

* Unfortunately, since market prices have risen a bunch in recent years, that means expectations of forward returns for the market is necessarily much reduced. Less margin of safety (if any) and less potential reward. Those with a long-term investing horizon shouldn't be cheering as the market goes higher. They should be hoping that market prices relative to per share intrinsic values becomes more favorable again. That's why bear markets are a good thing for those with a long investment horizon. So, essentially, indexes are likely to do relatively better than most active participants but it seems wise to assume that the absolute results from these current levels won't end up being all that wonderful. Losses, even if only temporary, are much more likely near current valuations. The market can, of course, go on to become even more expensive but the risks will be increasing. Things seem more risky during a bear market but that's simply not the case. Price can be the great regulator of risk.
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Friday, October 3, 2014

Buffett: We Ignore the Macro Factors

Buffett on CNBC yesterday:

"We look at opportunities, as they come along, we try to figure whether we can understand the long term economic prospects of the business. A lot of times the answer is no, then we forget it. We are not making any judgment about where the market is going or we are not looking at any macro factors.

My partner Charlie Munger and I have been working together now 55 years. We've talked about every business you can imagine and stocks. We have never had one decision that involved a macro factor. It just doesn't come up."

He then added:

"We don't get into macro. It just doesn't make any difference. We do decide whether we think we know where that business will be in 10 years or 20 years, and we know what we'll pay in terms of valuation."

Video: We don't look at macro factors: Buffett

With the above in mind, just consider all the time and energy that seems to be spent by experts who are trying to understand and predict what's going to happen based upon macro factors.

Munger once said "there's too much emphasis on macroeconomics and not enough on microeconomics. I think this is wrong."


"...I don’t think macroeconomics people have all that much fun. For one thing they are often wrong because of extreme complexity in the system they wish to understand.

So the two people who've had the most long-term investment success essentially ignore macroeconomics and focus on things can be understood.

 That's hard enough to do reliably well.


This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
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