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SURVIVAL of the FITTEST for INVESTORS
USING DARWIN'S LAWS of EVOLUTION to BUILD a WINNING PORTFOLIO
By DICK STOKEN
The McGraw-Hill Companies, Inc.Copyright © 2012Dick Stoken
All rights reserved.
The Investment Game
Ever since 1792, when a group of stockbrokers, meeting under the now famous buttonwood tree on Wall Street, agreed to form the New York Stock Exchange (NYSE), people have been trying to master the investment game ... but with little success.
Sure there have been winners! But in paraphrasing the words of Warren Buffett, head of Berkshire Hathaway and the most quoted investment guru of our time: imagine several million chimpanzees that had been taught to flip a coin, assembled in some immense stadium to participate in a chimp super coin-flipping contest with the media present. As the field narrowed, anxious media members breathlessly interviewed the finalists, asking them, assuming they could speak, what was the basis of their superior coin-flipping skills. And the chimps, honestly believing they possessed some special skill, would credit their success to a particular way of flicking their wrist, or perhaps to repeating some mantra while flipping. The public, meanwhile, listening to the commentator's excited rendition of the chimps' abilities, would believe that practicing such wrist flips or chanting magical mantras led to the chimps' success, and then would try to do the same.
Dear Reader: What if yesterday's and today's acclaimed stock market wizards are no different from a group of chimpanzee finalists?
Sounds silly? Agreed; it flies in the face of the way we Westerners like to think. We are children of a Newtonian mechanistic worldview. More than 300 years ago, Sir Isaac Newton excited our ancestors by solving the problem of the motions of the planets and, in doing so, birthed a new way to look at the world. The Newtonian mechanical worldview championed a chain of cause-and-effect logic and it became the blueprint for a large-scale search for knowledge. As Westerners sought to match cause and effect, identifying a cause for every effect and potential effects of any cause, they created a clear pattern of thinking that allowed us to master problems that had baffled mankind since the ancient Greeks. Over the following centuries, men and women vastly increased our collective store of knowledge; they figured out how to build spaceships that were able to take astronauts to the moon; they invented machines that spearheaded enormous leaps in our world's material wealth; they found cures for numerous diseases that had formerly cut short much of human life; and they designed a system for citizens of a political entity to govern themselves through representatives.
All this is certainly true, yet, whether or not this same type of knowledge can be translated into models that will allow us to reliably predict the future is questionable. Respected observers insist that in the long run the stock market cannot be beaten. This means that over time the participants, including so-called experts, will be unable to better an average return obtained from investing in an index of stocks, without taking on a greater amount of risk.
IS THE MARKET BEATABLE?
At the beginning of 1970, there was a haystack of 355 equity funds. We can imagine those funds were run by some of the most savvy and highly paid Wall Streeters, who were backed up by large and highly educated support staffs and enjoyed a huge information advantage over John Q. Public. At the end of 2005, 36 years later, according to John Bogle, founder of the Vanguard Group, 223 of those funds no longer existed. There may be a lot of reasons why funds disappear, but not many of the reasons are good. Of the 132 survivors, only 45—not quite 13 percent—had, even by the tiniest of margins, beaten the Standard & Poor's (S&P) 500. A lonely nine (2.5 percent) achieved that feat by more than a meaningful 2 percent per annum. So an investor's job would be to find those nine needles of outperformers. But wait! Six of the outperformances peaked between 1983 and 1993 and have been struggling ever since. Had you waited more than 7 years to identify those winners, you would have missed most, if not all, of the outperformances. Okay, chimp, go out and find that 1 percent (the three remaining outperformances from the 1970 crop) who are going to be, and remain, winners.
Morningstar, the leading fund statistical rating service, ranks or categorizes funds from one to five stars, with five being the best performing funds. Mark Hulbert, who keeps tabs on real live investment returns, created a hypothetical portfolio that was adjusted to hold only Morningstar's five-star funds. During the 11-year test period, 1994 to 2005, the return was 6.9 percent, which fell way short of an 11 percent total market return during that period. The five-star returns were not even close.
Then there is the story of Bill Miller, star portfolio manager of the Legg Mason Value Trust Fund, who by the early years of the twenty-first century had become an investment legend. By year-end 2005 he had beaten the S&P 500 for 15 straight years. Wow! This was such a statistically improbable event that it was compared to Joe DiMaggio's incredible 56-game hitting streak, a one-in-a-million likelihood. During his streak Miller scored a 15.3 percent compounded return, 2.4 percent better than the S&P 500. It certainly appeared as if we had identified a true investment sage. Magazines, newspapers, and TV commentators fell all over themselves in reporting the "Bill Miller" story and, of course, each of them gave their take on how and why he was such a superior investor. In January 2004, Money magazine described Bill Miller as "the country's greatest mutual fund manager." Miller, at that time, had beaten the S&P 500 for 13 years in a row. Money computed the odds of doing so at 149,012 to 1. In November 2006, Fortune magazine's managing editor, Andy Serwer, seconded Miller's status as "the greatest money manager of our time."
Well what happened? In early 2010, the media's favorite investment "chimp" was replaced as Legg Mason Value Trust Fund's manager. Miller's record, which then included a decline of 55 percent in 2008, was so bad that his Value Trust Fund was ranked by Morningstar close to the bottom for the past 3, 5, and 10 years. The 3-year record was particularly dismal. His fund had an annualized loss of 20 percent, compared to a loss of only 9 percent for the S&P 500. Had you identified "the country's greatest mutual fund manager's" star (!) quality after seven straight S&P 500 beating returns and just prior to the time that Wall Street was beginning to take notice, and invested at the end of 1997, you would have been a net loser when Miller was benched. On the other hand, those investors who ignored Miller's cheerleaders and instead purchased the S&P 500 at the end of 1997 were up approximately 41.5 percent.
CAN WE FORECAST?
Let's now pivot and look at forecasting, which has a lot to do with investing and ask the same question: Can we forecast?
During the 1920s, there was an infectious optimism in the United States. Almost all of the nation's leaders believed there was an enormous pile of new wealth awaiting the middle class—just around the next corner, we were told. In 1929, when the eminent John J. Raskob—chairman of the finance committee of General Motors, vice-president of E. I. DuPont de Nemours & Company, director of Bankers Trust Company, and chairman of the Democratic Party's National Committee—wrote how easy it was to accumulate wealth in a popular article in the Ladies Home Journal entitled, "Everybody Ought to B Rich," Americans everywhere nodded their heads in agreement. But when the middle class turned that corner, the goddess of prosperity was nowhere in sight; instead it was the mugger of a depression waiting for them.
In the late 1970s, a baffling inflation had imbedded itself into American economic life; it was turning the nation's financial markets upside down, while a bloated U.S. federal government was encroaching more and more into people's daily lives. To further compound worries, Japan's economy was on the march, crippling such stalwart American industries as autos, steel, and electronics, and threatening to uproot much of the rest of the American economy. Serious Americans plausibly speculated that the nation was in terminal decline and thought the country was headed toward some sort of state socialism. What followed instead was a renaissance of American "free-market" capitalism, just the opposite of what most Americans had been expecting.
Do you remember what the investment world looked like in 1980? The majority of people have long since forgotten, but to refresh memories, the most popular view was one of growing energy shortages and mind-numbing inflation. Howard Ruff and Douglas Casey, the fashionable financial gurus of the time whose best-selling books were being read by millions, were prophesying that the world's supply of oil, the oxygen of industrial economies, was shrinking and oil's price was destined to soon top $100 a barrel; furthermore, inflation, already in double digits was headed into triple digits. The heavy lifters in their recommended portfolios were: gold and silver. As for stocks: Forget it! They were a dead asset, with limited upside potential at best. In fact, a year earlier, Business Week magazine, in its cover article, loudly proclaimed, "The Death of Equities." So what happened?
Fast-forward 19 years later, to early 1999:
Oil was trading at about $11 a barrel, almost 75 percent below its 1980 price and nearly 90 percent beneath its $100 forecasted price.
Gold was changing hands at $290 an ounce, down about 65 percent from its 19-year earlier price.
Silver was trading at about $5 an ounce, nearly 90 percent below its 1980 peak price.
The "dead" asset class equities, the S&P 500, was trading at about 1,275, or up about 1,175 percent from its 1980 low.
These widely accepted forecasts achieved a perfect score; dead wrong on all four counts.
Japan's economy continued to thrive throughout the 1980s, in fact, so much so that, almost daily, new books were being published, shouting that Japan's "miracle" economy was about to grind the American and Western economies into the dust. As Clyde Prestowitz, president and founder of the Economic Strategy Institute, wrote in 1988, "Japan has created a kind of automatic wealth machine, perhaps the first since King Midas." However, most authors were kind enough to explain the Japanese economic-business model, which was quite different from the Western model, and urged America to hurriedly adopt Japanese business methods.
How did the highly touted Japanese model do? In early 1999, while world stock markets were trading at more than three times their early-1990 levels, stocks in Japan were trading nearly two-thirds below their 1989 year-end prices. In Japan, the 1990s had become the "lost decade." It was a 10-year period of economic stagnation, during which time real estate markets collapsed, bad loans crippled the Japanese banking system, and pension funds began running short of money to pay retirees. To say the least, there was a clear lack of interest in writing or talking about Japanese business savvy by the century's end.
In the mid-1980s, Americans were caught up in a budget deficit mania. Worrywart commentators were talking about a sea of red ink, stretching out as far as the eye could see, that would surely bankrupt the United States ... unless the Reagan tax cuts were reversed. During a 1984 presidential debate, Walter Mondale told cheering Democrats that there had to be a "new realism" in government. "Let's tell the truth," he challenged. "Mr. Reagan will raise taxes and so will I. He won't tell you. I just did." Reagan won that election and did not raise taxes. In fact, he lowered them ... again.
Taxes would not be raised (meaningfully) until the 1990s, and then the upward adjustment would offset only a small portion of the prior Reagan tax cuts. While government debt did quadruple from 1980 until 1992, the American economy did not buckle. Rather, it surged to unprecedented heights, far surpassing Japan's "miracle" economy. And who would have thought that from late 1982 until the end of 2000, a period of 18 years, the nation's economy would experience only one 8- month recession? Never before had an industrial economy experienced such a long run of nearly uninterrupted economic good fortune. As for government deficits as far as the eye could see, well, by the turn of the century, they had become surpluses as far as the eye could see. (The red ink of the early twenty-first century is a new matter—not a direct causality of the Reagan tax cuts.)
Oh yes. Let's not forget the widely predicted post–World War II depression. Sewell Avery, head of US Gypsum, had retrenched on the eve of the Great Depression, allowing his company to sidestep the troubles that were battering most American businesses. Two years later he was anointed to head Montgomery Ward by John Pierpont (J.P.) Morgan, the largest shareholder of the floundering catalog merchandiser. Avery, the poster boy of inflexibility, hunkered down after World War II, attempting once again to ride out the predicted storm. But there was no depression. Instead the country began a 25-year period of unprecedented prosperity and soaring share prices. And Avery, waiting for hard times that never came, sat on the sidelines while Montgomery Ward shrank to a third-rate company.
These consensus "forecasts" were ALL laughingly wide off the mark. No wonder the late Peter Drucker, who by general consensus had been considered America's foremost business management authority, threw up his hands and said, "Forecasting is not a respectable human activity."
USING NEWTONIAN THOUGHT TO BEAT THE MARKET
So how do we square this "nothing seems to work in trying to best the market" view with our Newtonian mental construct? We don't!
As far as helping to predict market outcomes, the Newtonian "cause-and-effect" logic appears to have been worthless and perhaps even somewhat harmful. Perhaps the best we can do, according to John Bogle, who thinks the market is smarter than us all, is merely mimic the market.
If we hope to have a chance at outdistancing the S&P 500 in total returns, we need a better picture of how markets work. But first, let us pause for a short history lesson of the stock market landscape we are operating in.
The Investment Environment: An Ever-Changing Landscape
The year 1926 was the chosen starting point of a study conducted under the auspices of the University of Chicago—now known as the CRISP database—to tabulate complete equity results, encompassing all stocks. From that date on, stock market data has been considered complete and reliable. It is also the most legitimate marker for a beginning to stock market history.
Today, Morningstar keeps the CRISP flame alive in its annual publication, Ibbotson 'SBBI' Classic Yearbook, which updates yearly returns on Stocks (S), Bonds (B), Bills (B), and Inflation (I). Most of the figures we will use in the coming chapters are from the Ibbotson 'SBBI' Classic Yearbook. Table 2-1 contains a year-by-year compilation of returns for stocks, intermediate government bonds, and 90-day T-Bills.
To follow the contours of an investment through time, I am going to introduce a new concept for many of you: Net Asset Value (NAV). NAV starts with a hypothetical $1000 and adds or subtracts each subsequent year's performance to the prior year's NAV to derive a total wealth map. Take a look at Table 2-1. In 1926, equities were up 11.62 percent; the original $1000 was multiplied by that percent (1.1162 x 1000) and added to the original $1000 to get a year-end NAV value of 1116. In the following year, stocks were up another 37.49 percent; this number was used to multiply the prior year's NAV of 1116 and resulted in a 1927 year-end NAV of 1534. A losing year, such as the -8.42 percent in 1929, was used to multiply the prior year's NAV, only this time the figure, which was 185, was subtracted from 1928's NAV of 2203, resulting in a new 1929 NAV of 2018. This annual NAV wealth map allows us to calculate compounded (CMPD) returns or drawdowns (DDs) in equity for any calendar-year interval.
As we can readily see, during the 85-year period ending on December 31, 2010, the stock market, including reinvested dividends, delivered a generous compounded annual return of 9.87 percent. An original $1000 investment at the beginning of 1926 blossomed into $2,982,470 by the period's end. This return was far larger than those from bonds—long-term (20-year) Treasuries returned a paltry compounded 5.5 percent, while the return on intermediate (5-year) government bonds was 5.4 percent (see Table 2-2)—and almost any other asset class that had a sufficiently long enough history to measure.
Furthermore, note that these stock market returns beat a riskless 90-day T-Bill in 55 of the 85 years (Table 2-1). That means it paid to take on risk, via equities, approximately 65 percent of the time.
No wonder leading stock market academicians, such as Jeremy Siegel, Professor of Finance at The Wharton School of the University of Pennsylvania and author of the widely read investment classic Stocks For the Long Run, stood on soap boxes herding investors into equities only, buy-and-hold (B&H) portfolios with the strict caveat to hang on through thick and thin. But there is another side to the stock market equation ...
Most would answer the risk question by referring you to the standard deviation of stock returns which was 20.39 percent, as shown in Table 2-1. Traditional risk analysis uses standard deviation—the variation in annual returns from its average—as a proxy for volatility, which is translated to mean risk. A higher standard deviation means more volatility, and is assumed to imply greater risk and vice versa. Increased volatility certainly does seem to capture certain aspects of risk. Strategies that use more leverage or higher betas (a measure of the volatility of the asset compared to the volatility of the financial market as a whole) are, indeed, likely to display higher standard deviations.
However, standard deviation suffers from assuming investment returns fall into a "normal" distribution pattern, much like in physics or general statistics. But when applied to investing, that normal distribution vastly underestimates tail risk. Tail risk refers to outliers on the downside that far exceed what should be normal boundaries to a price decline, such as in 2008 or the one-day stock market plunge of 23 percent in October 1987.
Excerpted from SURVIVAL of the FITTEST for INVESTORS by DICK STOKEN. Copyright © 2012 by Dick Stoken. Excerpted by permission of The McGraw-Hill Companies, Inc..
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