Thursday, May 03, 2007

 

Investing for Dummies

My post on the first quarter GDP numbers prompted my friend Kevin to send me a couple of emails concerning investment and the validity of investment canon the efficient market hypothesis and the capital asset pricing model.


1.3% Maybe record record earnings trumps bad economic news? I don't know ... that was the explanation my Ohio State MBA friend/coworker gave me. He likes to spout off crap about CAPM and EMT like they are Laws of Nature. He is as certain of these laws as he is gravity. Which is why he is dumping his retirement into an S&P 500 Index Fund. I hope for his sake we don't enter a generally long, flat, down trending stock market over the next 30-40 years.

Doesn't EMT just give fund managers an excuse or reason why they can't beat the market all the time? If an MBA was worth the tuition spent on it wouldn't fund managers beat the market most of the time.? Instead we learn theories which excuse our mediocrity in the business world.

Isn't it strange that one of the owners of LTCM was Myron S. Scholes of the Black-Scholes Model? Quite the expert, yet responsible for one of the biggest corporate bailouts of all time


Later he wrote,


I asked you once what you do and I think you said something like you essentially take advantage of mispricings or inefficiencies in pricings. If you have an MBA I was not attacking you. I simply am trying to point out that people are lead to do things and believe things with their money without really thinking it through. I for one need to learn what the hell I'm doing with my retirement plans. I'm afraid some of us sheeple are being led to the slaughter by dumping a % of our hard earned income into mutual funds. Basically we are lazy and do things like dump our dough into S&P 500 index funds with out thinking that their is a possibility that these funds could move steadily downward into our retirement. The experts can be wrong as was Myron Scholes.

For the record I have a M.S. in Financial Markets and Trading and I am not insulted when someone points out the failings of modern finance. In defense of MBAs, many of them are awarded to people who do not go into finance and those who do are taught that attempting beat the market is foolish because of the EMT. Dumping money into mutual funds, specifically index funds, is a good way to invest. The biggest problem when it comes to investing is discipline. A program of investing a certain amount of your income is a very worthy exercise. I would suggest taking a look at ETFs which might have lower fees.

Kevin's worry is that blindly putting money into the stock market is dangerous because you might need that money when the market is performing poorly. My belief is that by adding a simple valuation component to your investment decision you will be able to avoid the danger of being more or less fully invested in 1929, 1970, or 2000 when you need the money in 1933, 1974, or 2003, respectively. Most investment advisors will take age into account when recommending a mix of assets. Say 70% in stocks when you are 30 and 30% when you are 70. I would add a few valuation measures like P/E ratio of trailing earnings, the Q ratio, or any number of market value to income measures. The purpose is to greatly reduce the risk of buying into a bubble without missing out on the price appreciation.

You don't actually need to look at valuation in order to benefit from a risk reduction program. For example, if you had set a percentage of assets to be held in stocks of 50% over the past ten years and had readjusted your portfolio quarterly then you would have been selling during the peaks and buying during the troughs. The point is that risk reduction by balancing your portfolio will greatly reduce volitility in your portfolio. And we being human beings, a rational, hands off decision making process is always a good thing when times are either so good or so bad that the animal spirits of the majority clouds our reasoning processes.

I hope this helps. What I want to do is to encourage you to invest and to give you a way to reduce your risk without making irrational decisions. In every way your investment process should be programatic because the average layman should not trust himself to dispassionately make these choices.

Kevin, your MBA friend is correct for the most part. The greatest risk is that fear prevents us from investing. Buying low and selling high are much more difficult than it would appear. I would be interested in knowing what he thinks about adjusting portfolios based on market valuations. The fundamental mistake in modern portfolio theory is the assumption of rational markets. The original Black-Scholes option pricing model used a normal distribution for the stock market which we know now is very flawed. Price movements do not follow a normal distribution. Large movements are much more common than predicted. Also, markets can price stocks based on nothing to do with the fundamentals of the business and that this irrational pricing can continue for years. Take a look at behavioral finance topics like loss aversion to understand that human psychology plays a much greater role in stock market valuations than the EMT would allow.

P.S. One thing I would like to add and that is most Americans are not diversified outside of American assets to the extent that they should be. With the dollar falling like it has been this is fairly obvious. Right now being a global asset bubble might not be the best time to start overseas investing but a program of shifting assets over time is a prudent, risk reducing choice.

Diego adds: Where to invest is just not an exact science. I think many people contribute to retirement investment plans such as mutual funds through a 401k or IRA and invest 'blindly' because they are never sure weather the 'experts' know more than they do. Like going to a doctor you have to weigh the professional opinions with your own personal experience with your body to determine the best plan of action.

I passed on investing in property 10+ years ago to invest as much as I could in a 401k plan only to see that tank later on. I don't think I lost more than I put in but there was some serious shrinkage in value around 1999/2000. If I had bought property in 1995/1996 I would have been much better off. But I also would have done well if I converted my 401k assets to cash before they tanked.

However I also remember the advice from some that when the Dow reached 6k back in the 1990's that investing in stocks was a bad idea since there was sure to be a market correction coming. Investing is gambling. You just need to play the odds as best you can and realize that you might lose. I don't regret my decisions to any difficult degree because they were sound choices based on what I knew at the time.

Bill C:

Diego, Recent years have been very difficult investing enviroments because of the huge expansion of credit has caused huge jumps in price vs. income. I have a feeling that the property investors of today will be wishing they had cashed out rather than held in 5 years. Here is an article outlining why renting can be a smart financial decision especially in today's housing market. Well worth a read. I would add that rents are about the same as when we rented an apartment 6 years ago.

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