Shiller P/E (does it matter?)

Coffina: One metric that I've been looking at a lot recently is the Shiller price-to-earnings ratio, and this metric uses 10-year average of real GAAP earnings in the denominator. The advantage is that it's been much more predictive historically of future total returns than one-year price-to-earnings ratios, which really hold little to no predictive value. A one-year price-to-earnings ratio will tell you, for example, that the valuation looked in line with historical norms right up to the financial crisis, and then it actually peaked in late 2009, after the recovery was already well under way.

In contrast, the Shiller price-to-earnings ratio was at relatively high levels, about the 80th percentile relative to the last 25 years, or in other words, it had been lower 80% of the time in the lead-up to the financial crisis. And then in the depths of the financial crisis in late 2008 and early 2009, the Shiller price-to-earnings ratio was seeing levels that it hadn't seen in 20-plus years.

So, the Shiller P/E tends to be a lot more predictive of future total returns, and that measure right now is at about 26, which is about the 68th percentile relative to the last 25 years. So, in other words, the market has in general been cheaper, based on this measure, 68% of the time since the late 1980s. That's certainly a cause for concern based on recent history.

So, what we've seen historically is that any time the Shiller P/E is above, say, 25.5, which is about the 60th percentile relative to the past 25 years, subsequent total returns for investors have been very poor, on average in the low-single digits, with some very severe drawdowns

Glaser: So should investors then be preparing for a big sell-off, or a repeat of 2008?

Coffina: It's very, very hard to say. It's one thing to say that the market is richly valued relative to historical standards. It's a completely different thing to say that this means stocks are going to decline over the next one year, three years, or even five years. As I mentioned, in 1996 and in 2002, the S&P 500 was valued at similar levels and went on to have a great run over the next five years until it ended in a crash. So even over a time period as long as five years, saying that the market is relatively richly valued relative to history doesn't tell you much about what stocks are actually going to do in the near term.

Glaser: Over the next 10 years, then, from these valuation levels, what kind of total return should investors be thinking about?

Coffina: Well, that's a great question, and I wish I had a better answer for you. It's going to largely depend on what happens to price-to-earnings ratios. I mentioned before that over the last 25 years, the Shiller P/E ratio took a big step up versus the prior 100 years. The measure used to be around 14-15. Over the last 25 years the norm has been more like 23-24. So anyone who is looking at a measure like this in, say, the early '90s would have decided that, say, 1992 was a great time to sell stocks, and they would have missed out on the '90s bull market, and even through the 2002 crash, they would have missed out on total returns in the high-single digits.

There's definitely a caveat to this whole kind of analysis; market conditions can change, and past is not necessarily a good indicator of what's going to happen in the future. In particular, in the environment that we're in right now, if interest rates stay as low as they are currently, that can certainly justify sustained higher valuation levels going forward. I'm not saying that's going to happen, but it's certainly possible.

[8/24/14 Mitch Zacks chimes in]

Currently the CAPE ratio is flashing some warning signs as it hits levels that have previously been seen only before some of the major market sell-offs of the past century. Interestingly enough, however, valuation multiples based on trailing twelve-month earnings and future earnings estimates are showing a market which is expensive but not unusually extended given current interest rate levels.

The question for investors is, of course, whether the high reading of the CAPE ratio should prompt a reduction in equity exposure.

Now, I am a little biased as Zacks created the quarterly consensus earnings estimate which effectively enables valuation multiples to be calculated based on forward looking earnings data. P/E multiples based on analysts' earnings estimates show a market that is more expensive than historical, but not at the eye-popping levels shown by the CAPE ratio. Despite this bias, at the end of the day, I do not think long-term equity allocation should be adjusted based on the current high reading of the CAPE ratio.

First and foremost, I have learned over many years it never makes sense to time the market. It does not work. It does not work if you react to newsletters, earnings trends, IPO activity levels, discounted cash flow models, P/E multiples, gurus, magazine articles, tea leaves or sunspots.

In fact, one of the few metrics that does seem to have some value in terms of predicting future market performance is interestingly enough, tracking what Wall Street investment strategists—the analysts who set equity and fixed-income exposure of brokerage firm model portfolios—are recommending to investors and promptly do the opposite. The reason this methodology may work is that by the time multiple strategists are calling for the market to go in a certain direction, the information they're responding to is already reflected in stock prices. As a result, the market surprises by reacting to new information and moves in the opposite direction. This rule of thumb would currently indicate increasing equity exposure as many of the strategists are recommending a reduction in equity exposure.

Additionally, there are a few problems with the CAPE ratio. All the methodologies of calculating P/E multiples are designed to compare current prices to future expected earnings. There is agreement amongst investors that the key metric in stock market valuation is future earnings.

No one buys a stock such as Apple ( AAPL ) based on what the company earned over the past twelve months. Investors instead focus primarily on what AAPL will earn in the future and whether those earnings are greater than expectations currently built into the stock's price. As a shareholder of AAPL, you are valuing the company based on the future theoretical dividends AAPL can potentially pay as opposed to the historical dividends it has paid. The past earnings data, however, is often used as benchmark for predicting what the future will bring. Want to know what Apple will earn next year? Look at what they earned last year and then estimate how many more iPhones they will sell.

The CAPE ratio makes the assumption that historical ten-year inflation adjusted earnings are a good predictor for corporate earnings over the next ten years. As a result, the CAPE multiple is showing an extremely high level because current stock prices are being compared to trailing ten-year historical earnings.

Essentially, ten-year historical corporate earnings numbers may not be a good predictor of the future as they include the years 2008 through 2010 when corporate earnings were incredibly depressed due to the financial crisis. Therefore, an investor's faith in the CAPE ratio as a predictive tool of future market performance comes down to whether or not corporate earnings will revert to historically depressed levels.

This depends to some extent on whether the financial crisis is seen as a recurring event or a once in a seventy-five year outlier. I am certain the financial crisis is an outlier as opposed to a recurring event, and as a result, the CAPE ratio is likely not as meaningful as it has been at other times.

Corporate Earnings, Inflation and Interest Rates

Unfortunately, another argument why corporate earnings will mean-revert is because corporate profit margins, which are at all-time highs, will move back to historical lower levels. This argument has a stronger leg to stand on because if wage inflation starts to pick up, corporate profit margins should come under some pressure.

As I have written numerous times before, the market's P/E multiple is higher than its historical average primarily because interest rates are substantially lower than what they have been. If interest rates remain below historical levels then the market's valuation is reasonable. It all comes down to whether wage inflation materializes. If it does, the market will be in for some rough sledding with decreasing corporate profit margins while the P/E multiples come under pressure due to rising interest rates.

Despite my anticipation of inflation as a result of quantitative easing, no inflation has actually materialized for more than two years. The trillions of dollars sloshing around the fixed income market buying and selling U.S. government bonds is telling us that interest rates are expected to remain low for quite some time. The yield on the 10-year would be below 3% only if inflation was expected to remain incredibly low for a very long time. 

Though I am convinced that once the yield on ten-year U.S. government bonds starts to revert to its historical levels, stock market valuation multiples, regardless of how they are calculated, will come under pressure. Ultimately, the future direction of the market is going to be dependent on whether interest rates remain low or inflation returns to the system.

So Where Is the Market Headed Now?

While I do not think the market is at a dangerous level of valuation, I do feel that future returns in the market will be lower than they have been over the past five years. Rates are going to have to go higher and valuations are going to have to come down.

[That's safe to say.  The past five years have returned 16.58% mainly because it doesn't include 2008 which returned -37.00%.  The returns have been (starting in 2009): 26%, 15%, 2%, 16%, 32% (for an average of 18%, 16.58% for the five years from today).  AAPL returned 147%, 53%, 26%, 33%, 8% (for an average of 53%!, 34% for the five years from today).  AAPL dropped 57% in 2008.]

200 years of the stock market (actually only 189)

I'm a glutton for historical numbers, especially pertaining to stocks. Awhile back I came across a post that had a histogram of the overall stock market returns since 1825. More on the numbers shortly...

Prior to reading that post, I was already aware that, from the end of 1814 to the end of 1925, the U.S. stock market experienced compound annual growth of about 5.8% per year. This is based on data put together by Robert Shiller, and this measure used a price-weighted index, which has many flaws but is the way that most of the indices are measured today.

To use a different time period and a different yardstick, Buffett once mentioned that the Dow went from 66 to 11,219 during the 100-year period during the 20th century, which is a 5.3% CAGR. Adding dividends to that figure, and shareholders might have realized 7-8% annually or so.

To use a third historical time period, I noticed in Buffett's annual shareholder letter that the S&P 500 has averaged 9.8% annually over the last 49 years (since he took over at Berkshire).

I think the last 200 years provides pretty good evidence that over the very long term, I feel comfortable expecting the market to average somewhere between 6% and 9% annually including dividends (if I had to guess, I'd be closer to 6 than 9).

Take a look at the last 189 years of general stock prices:

Some anecdotes I find it interesting to observe the results of 189 years between 1825 and 2013:

• The market had 134 positive years and 55 negative years (the market was up 71% of the time)
• 44% of the time the market finished the year between 0% and +20%
• 60% of the time the market finished the year between -10% and +20%
• Only 14% of the time (26 out of 189 years) did the market finish worse than -10%
• Only a mere 4.8% of the time (fewer than 1 in 20 years) did the market finish worse than -20%

So to put it another way (using the 189 years between 1825 and 2013 as our sample space), there is an 86% chance that the market finishes the year better than -10%. There is a 95% chance the market ends higher than -20%. And as I mentioned above, there is a 71% chance that the market ends any given year in positive territory.

One last observation: the market was 5 times more likely to be up 20% or more in a year (50 out of 189) than down 20% or more in a year (9 out of 189)!

Now, lest my readers suspect me of predicting further gains... let me make it clear that I'm not trying to make a case that I think the market won't or can't go down, or even go down a lot. On the contrary, after 5 years in a row of not just positive years, but exceedingly above average gains, we are certainly "due" for a down year. After all, the market finished the year down 29% of the time over the past 189 years, or about once every 3 or 4 years.

I just think that it's difficult to predict when the down year--and certainly when the next big crash will come. Make no mistake, the market will crash from time to time. The economy will suffer another credit crisis. It's just difficult to know when. The stock market certainly will go through another 10% correction in the near future. It will likely go through a 20% correction in the near future. There have been 12 of those corrections since the mid-'50s when the S&P 500 index was instituted, or about one every 5 years. We haven't had one since early 2009 so we're due for one of those as well.

Although certain to happen again, crashes are rare. The 2008 type scenarios are extremely rare. Only 3 times since 1825 did the market finish a calendar year down 30% or worse. That's about once every 63 years. People tend to overestimate the probability of a market crash when one recently occurred. The storm clouds of 2008 are in the rearview mirror, but they are still visible and the effects of the storm still evident.

They key thing to remember is that when you own a stock, you own a piece of a business. Graham's logic is as simple as it is timeless. It really helps to remember that you don't own numbers that bounce around on a screen, you own a business that has assets, cash flows, employees, products, customers, etc. Just like the owner of a stable, cash-producing duplex located in a quality part of town isn't frantically checking economic numbers or general stock index prices on a daily or weekly basis, nor should the owner of a durable business that produces predictable cash flow – purchased at an attractive price – be concerned about the day-to-day fluctuations in the quoted price of his share of the company.

As Munger said, sometimes the tide will be with us and sometimes the tide will be against us, but the best thing to do is to just continue to swim as competently as we can. Although ocean tides are much easier to predict than the direction of the stock market, I still think it's best to focus on swimming as opposed to anticipating the changes in the tides.

-- John Huber, Base Hit Investing

understanding the business

Many investors equate understanding the business to understanding the product or service of the business. I certainly wasn’t too far from that line of thinking in my earlier investment journey. I was ignorant enough to think that Coca-Cola, MasterCard and Wal-Mart were without doubt within my circle of competence. I don’t drink Coke, but I certainly know what Coke is. Heck, better yet, I even know Cherry Coke and Diet Coke. I have two credit cards that have MasterCard sign on them and I use them very often. I also go to Wal-mart occasionally. How could I not understand these businesses? They are part of our daily lives.

It all changed when I heard the following message from Mr. Buffett in his talk to UGA students:

“I have an old-fashioned belief that I can only make money in things that I can understand. And when I say ‘understand,’ I don’t mean understand what the product does or anything like that. I mean understand what the economics of the business are likely to look like 10 years from now or 20 years from now. I know in general what the economics of, say, Wrigley chewing gum will look like in 10 years. ”

It was truly a "eureka" moment for me because I have taken it for granted that "understand" means understand what the product does. We all know how to use a credit card. But that doesn’t mean we understand MasterCard. For readers who think you understand MasterCard, I challenge you to answer the following questions about MasterCard. What is the business model of MasterCard? What is MasterCard’s gross and net margin and why? Why would banks issue credit cards with MasterCard, and why do merchants accept them?

... I hope by now, you can see the differences between understanding the product of a business and understanding the economics of the business and why it matters enormously to us. It is the difference between knowing the name of something and knowing something, which are two levels of understanding. Very often we understand both the product of a business and the economics of the business as our research moves along, but great danger remains when we mix up those two concepts, especially when it comes to the brands that are ubiquitous in our daily lives.

-- Grahamites

the nature of long-term investing

I think it's in the nature of long term shareholding of the normal vicissitudes, in worldly outcomes, and in markets that the long-term holder has his quoted value of his stocks go down by say 50%. In fact, you can argue that if you're not willing to react with equanimity to a market price decline of 50% two or three times a century you're not fit to be a common shareholder, and you deserve the mediocre result you're going to get compared to the people who do have the temperament, who can be more philosophical about these market fluctuations.

-- Charlie Munger, BBC interview

Lazy Investing

here are 10 “think-like-an-amateur” secrets from our “Lazy Person’s Guide to Investing.” (review) Ten simple ways to get into peace-of-mind investing.

3. Peace of mind from knowing advisers have no special skills either

Actually it’s worse. Nobel economist Daniel Kahneman also used the casino metaphor in “Thinking, Fast and Slow,” neuroscience. Based on “50 years of research” he found that the “stock-picking skills” of managers and advisers is “more like rolling dice than like playing poker.” Their picks are no more “accurate than blind guesses.” In fact, “this is true for nearly all stock pickers ... whether they know it or not ... and most do not.”

5. Peace of mind: realizing markets are irrational, unpredictable, dangerous

Wharton School of Finance economist Jeremy Siegel, author of “Stocks for the Long Run: The Definitive Guide to Financial Market Returns and Long-Term Investment Strategies,” researched 120 of the biggest up and biggest down days in the stock market, the last two centuries. In only 30 of those big-move days did Siegel find a reason for market movement. In other words, 75% of the market’s biggest twists and turns in history were irrational and unpredictable black swans. Bottom line: 100% of the time Wall Street’s just guessing.

6. Peace of mind is deciding never to actively trade in the stock market

Active trading feeds anxieties and stress and kills peace of mind. Behavioral-finance professors Terry Odean and Brad Barber of University of California studied 66,400 portfolios at a major Wall Street firm for seven years. Three key factors reduced their returns: their stock-picking skills, transaction costs and taxes. Active traders averaged 258% portfolio turnover annually. But turnover was a mere 2% for buy-and-hold investors. Yet they earned seven percentage points more than the active traders.

8. Peace of mind means never trading on hot tips and emotions

Yes, the stock-picking and trading skills based on “gut feel” is invariably a loser decision. A Morningstar study says most investors get in and out of the market at the wrong time. Irrational exuberance fuels a buying frenzy at the top. Investors jump in, buy high, lose. Then when the market drops, they panic, sell, lose. You want peace of mind? Build your Lazy Portfolio.

9. Peace of mind vs. overconfidence: Your brain may be your worst enemy

A behavioral-finance study reported in Money magazine concluded that 88% of all investors have what psychologists like Kahneman call “optimism bias,” overconfidence. We take big risks, handicapping ourselves, lose. Then we make excuses. Over half the overconfident investors who think they are beating the market often underperform by 5% to 15%. But they can’t admit failure, so never learn. Bottom line: Our brains are often our worst enemies.

10. Peace of mind: Most day-traders don’t make a living, eventually get out

In the end, you wake up to the fact that trading is not the get-rich promises that overly optimistic newsletter gurus want you believe. Yes, you can trade online for a few bucks a pop. But you can still make lousy picks. Lose fast and furious. Another Odean-Barber study revealed that as many as 75% of traders lose money. And even the rare successful traders rarely make more than $100,000 a year. As David Dreman put it in his New Contrarian Investment Strategy, “Market timers, if they don’t die broke, rarely beat the market.”

[by Paul Farrell via roy]

see also Six Rules for Lazy Investors

follow the billionaires

Investors looking for a one-stop “buy and forget” guru-following strategy now have a couple of exchange-traded funds to choose from.

In June, I compared the Global X Top Guru Holdings Index ETF (GURU) to its chief competitor, the AlphaClone Alternative Alpha ETF (ALFA). Today, I’m going to throw a new index competitor into the mix: the iBillionaire Index. An iBillionaire Index ETF is in the works as well, though the sponsor did not have a specific launch date.

Let’s take a quick peek at each of these guru-following strategies and highlight their differences. At first glance, you might think the strategies are interchangeable and that there is no value in adding another “me too” ETF. But the strategies each have unique features that can make each better than the others under the right set of market conditions.

ALFA was the first guru ETF to come to market, beating GURU by about a month. It also happens to be the most complex of the three. The AlphaClone index ranks hedge fund managers by a proprietary system and equally weights their top holdings. There is an allowance for overweighting if a stock has multiple guru owners. For example, a stock held by twice the number of managers would have twice the weighting in the index.

ALFA has one other noteworthy feature: It has a “dynamic hedging” mechanism that allows it to be up to 50% short during a prolonged market downturn. In ALFA’s case, the ETF will shift half of the portfolio into an inverse S&P 500 fund when the S&P ends a month below its 200-day moving average.

GURU, which is based on the Solactive Top Guru Holdings Index, runs a simpler strategy. GURU’s portfolio is simply an equally weighted mix of the “high conviction” picks of the hedge fund managers that Global X follows. Only managers that run concentrated portfolios are considered, but beyond that, there really is no other criteria.

The iBillionaire Index takes a slightly different approach. To start, it limited its pool of gurus to “financial billionaires,” or money managers who have amassed personal fortunes of over a billion dollars.
But secondly — and most importantly — its holdings are limited to constituents of the S&P 500. Per iBillionaire,

“It is composed of the top 30 large-cap equities listed on the S&P 500 in which financial billionaires have allocated the most funds, providing ample trading liquidity, a well-known benchmark, and better results to equity indexation than capitalization-weighted indices. Devised from 13F filings, the iBillionaire Index provides investors an efficient and effective way to follow the smart money. In essence, the index works as though one gathered a group of billionaires and asked them to come to a consensus as to which S&P 500 stocks are the best bets.”

With that said, which guru-following ETF strategy is best?

It’s really going to depend on the kind of market you’re in and what you’re using as a benchmark. ALFA’s ability to go short is a tremendous asset in a sustained bear market and will almost certainly cause it to outperform GURU and iBillionaire’s index. But in a sideways market or a volatile zig-zagging market (not exactly technical terms, but bear with me), it’s going to get whipsawed. It’s the curse of all trend-following models — they only work in a trending market. And in a long bull market, it won’t have any effect at all.

ALFA also has a small market-cap bias; Morningstar classifies it as a “mid-cap growth fund.”  GURU is considered a “large-cap” growth fund by Morningstar. iBillionaire — when its ETF is released — will likely have an even greater large-cap bias, as its mandate limits it to companies within the S&P 500.

I’ll summarize like this: If you think we might see a prolonged bear market, ALFA is the ETF for you; if not, GURU or an ETF based on the iBillionaire Index would likely be your better option.

***

article links

Brains vs. Brains: Which ‘Guru’ ETF Is Right for You? (6/13/13)

Your Newest Guru Investing Option: The iBillionaire Index (11/13/13)

iBillionaire To Launch New Billionaire-Tracking Guru ETF (2/21/04)

Investing Like A Billionaire With The iBillionaire ETF (8/2/14)

Want to invest like Buffett and Soros? Try this (8/3/14)

Buffett on the market valuation

As stated in the GuruFocus' "Where are We With Market Valuations?" article, "as pointed by Warren Buffett, the percentage of total market cap (TMC) relative to the US GNP is “probably the best single measure of where valuations stand at any given moment.”

What were his comments in a December 2001 Fortune article about the market in 2000?
Memorably he stated that "the ratio rose to an unprecedented level. That should have been a very strong warning signal."

[It reached 148.50 on 3/30/00]

What was the percent return of the S&P 500 after the Market Cap/GDP reached that "unprecedented level?"

[it dropped 43.1% in three years]

Has there ever been another time when Buffett touted a “very low-cost index?”
As stated on Reuters.com in the Buffett: Index funds better for most investors article by Jonathan Stempel dated May 6, 2007, “Buffett said at a press conference,” “A very low-cost index is going to beat a majority of the amateur-managed money or professionally-managed money.”

What was the Market Cap to GDP at that time?

[110.70 on 6/30/07]

What was the percent return of a “low cost” ETF that tracks the S&P 500 from May 6, 2007 to March 2009?

[it lost 53.6%]

What is the Market cap to GDP today?

122.3%

Considering the "best indicator where valuations stand," is currently near previous highs, might Warren actually be estimating that by the time his trustee is needed, the Market Cap to GDP will be at much lower levels?

If the valuation ratio reverts to those historical lows of 40%, and we are currently at 122%, does that mean a near 67% drop is possible?

Buffett's real secret

Buffett's real secret, beyond the IQ and emotional hard drive, is optimism. Berkshire is just a big levered up play on the economy. Trains, ice cream, Coke and banking. Buffett's famous for saying 'be greedy when others are fearful,' but what his real gift is believing in America and levering up on it. He generates cash betting against super catastrophic events in insurance and uses the money to bet against the collapse of the economy. That's been his formula for more than 60 years. If you take nothing else away from Buffett's notes it's that the richest man in the world got that way by betting against Doomsday. There's a lesson in that for all of us.

the biggest problem investors face

For years, there have been two principle adjectives used to describe the buy-and-hold investment style: Dead or alive.

The buy-and-hold style was, of course, labeled as dead during and after the financial crisis of 2008, when anyone who stayed with their investments saw their portfolios get cut in half.

The same style is purportedly now alive and well, as anyone who stuck it out after their losses -- or jumped into the market after the turmoil -- has seen a years-long rally that has recouped the losses and reached record highs.

Truthfully, the problem may be less with the style and more with the adjectives, because at least one leading money manager and behavioral finance expert now suggests that buy-and-hold is unrealistic and impossible.

This week, Natixis Global Asset Management committed $1 million to a three-year research project by the Laboratory for Financial Engineering at the Massachusetts Institute of Technology to help figure out how investors can bridge the emotional gap between a desire to generate superior investment returns and an aversion to taking risk.

In discussing the project, Andrew W. Lo, director of the Laboratory for Financial Engineering -- and manager of the ASG Diversifying Strategies Fund (DSFAX), a Natixis issue -- noted that the research is designed to tackle the really tough part of investing, the one where you put your hand back in the fire after you've been burned.

Standard advice typically amounts to "the market will be up in the long run," encouraging buy-and-hold for decades.

"That might sound like good advice because on paper when you take a look at the S&P 500 ($INX) over the last 10, 20 or 30 years the performance looks pretty good the longer you go," Lo said during an appearance on "MoneyLife with Chuck Jaffe." "The problem is that advice is just not realistic. You can't expect an investor to live through 2008-2009 and be perfectly happy to see their investments decline by 50 percent.

"You literally would have lost half . . . nobody is going to be rational to the point of not taking that information and reacting to it," he added. "We are all emotional in that context."

As a dedicated long-term investor, I can argue that point empirically by looking at my own portfolio, which went through the financial crisis virtually unchanged, with just a few small moves on the fringes but with the primary investments remaining the same.

I can also think back to those rough market times, however, and remember the nausea as the core of my portfolio was being gutted.

That emotion, in hindsight, is precisely why pure buy-and-hold can be, for most people, unrealistic.

Whether it is making moves on the edge of a portfolio or hiring a money manager who adapts and tries to guide the portfolio, it's basic human nature to want to avoid pain.

Lo compared it to a different human imperative.

"It's not credible to say to an investor, 'Here's a stock index fund, you ought to just keep your money in it and don't worry about it and leave it there for 10 or 20 years,'" he said. "That's like telling a teenager he or she ought to abstain; it might be reasonable advice in the long run, but in the short run it's very difficult to follow."

No matter what strategy investors opt to follow -- whether it is buy-and-hold or some rapid-trading, momentum-driven methodology -- the necessary personal ingredient for success is emotional discipline, the ability to stick it out.

C. Thomas Howard, director of research at AthenaInvest and author of "Behavioral Portfolio Management," told me recently that the biggest problem investors face comes in accepting an investment strategy and following it as it is; they pick a strategy that they understand and like, follow it easily during good times, but then have a tough time the moment they question a trade, a stock pick or the results in the market.

"You can't invest like a great investor if you're not investing just like that investor," Howard said. "You start to think you know better, or that there's just this one thing they are doing that you don't like, and suddenly you are changing. Now you are not following a successful system, you are modifying one; that may work out for you, or it may not."

Howard noted that by cherry-picking the parts of a methodology they like -- but ignoring or changing moves they're less comfortable with -- investors typically give themselves the wrong scapegoat for when something goes wrong. Invariably, they blame the adviser, newsletter editor, investment service or guru for failing when it was their own moves that altered the strategy.

"There's lots of ways to make money in the stock market, to be successful," Howard said. "The key is that you have got to master your emotions, follow a narrowly defined strategy, and consistently take only high-conviction positions over time."

Bring that back to the buy-and-hold strategy and recognize that the market is going to test your conviction. Ultimately, that's what leads Lo to say that buy-and-hold forever can't be done, even if most behavioral-finance guys say that it's the strategy investors might benefit the most from.

That said, investors need to do some self-examination and perhaps give their portfolio several different approaches, one where the core of their holdings is something as simple as buy-and-hold, but where there is enough money being invested in other ways that it creates enough conviction to stay invested in good times and bad.

In the end, it may not be that buy-and-hold is dead, impossible or unrealistic so much as it's that one piece of a puzzle for those investors who stomach it as one strategy in a multi-pronged attempt to come up with a portfolio they can live with in all market conditions; if you can't live with buy-and-hold when it feels more like a fruitless duck-and-cover play -- if you don't think you can witness the carnage of 2008 all over again and remain invested -- then you need to prepare for the days when the market again punishes buy-and-holders.

Knowing that now means you can protect against a downturn; finding out too late guarantees that your story will include the worst outcomes at the worst times.

***

in response, check the comments at the end of the article

Warren Buffett would also disagree.

“Unless you can watch your stock holdings decline by 50% without becoming panic-stricken, you should not be in the stock market.” – Warren Buffett

“If you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period?  Many investors get this one wrong.  Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall.” – Warren Buffett

[Actually, I think the article is largely correct as it describes the behavior of most people.]

Larry Kudlow

Haven't seen Kudlow's show on CNBC lately.  What happened?  Did the show get cancelled?  Did he get fired?  Did he move to Fox?  Let's see.

Ah, here's the story from March.

"The Larry Kudlow Report" will end its run on CNBC later this month, the network said on Friday, with host Larry Kudlow staying on as a senior contributor.

"Larry expressed his love of the network and personal pride in what had been accomplished on his program over the years but now wanted to slow down just a bit," the network's president, Mark Hoffman, told staff in a memo on Friday. "As an interviewer, he is unfailingly polite and energetic, skillfully grilling guests but always ending a segment graciously.

"Larry has always brought great enthusiasm to every program and appearance," Hoffman said.

The CNBC executive did not say what would replace Kudlow's program — only that the network was "working on plans" for the 7 p.m. Eastern time slot.

Kudlow, 66, will contribute to the "Business Day" program on CNBC, Hoffman said.

In January 2009, "The Kudlow Report" succeeded "Kudlow & Company," which aired from 2005 until October 2008. Before that, starting in 2002, the program was called "Kudlow & Cramer" — with investment guru Jim Cramer as co-host — and from 2001 to 2002, the program was called "America Now."

Featuring a mixture of business and politics, Kudlow's program hosted such guests as former President George W. Bush, former Vice President Dick Cheney, former Secretary of State Henry Kissinger, and current Defense Secretary Chuck Hagel.

Some of his guests from the business world have included media mogul Barry Diller and energy investor T. Boone Pickens.

A columnist and radio program host, Kudlow served in the Office of Management and Budget during the Ronald Reagan White House, worked as chief economist at Bear Stearns on Wall Street, and served as an economist for the Federal Reserve Bank of New York.

[He's only 66?]

Social Security and Medicare status update

CHICAGO (Reuters) - If you worry about the future of Social Security and Medicare, this is the week to get answers to your questions. The most authoritative annual reports on the long-term health of both programs were issued on Monday, and while the news was mixed, there are reasons to be encouraged about our two most important retirement programs.

Under the Social Security Act, a board of trustees reports annually to Congress on the status and long-term financial prospects of Social Security and Medicare. The reports are prepared by the professional actuaries who have made careers out of managing the numbers and are signed by three cabinet secretaries, the commissioner of Social Security and two publicly appointed trustees - one Republican, one Democrat.

Here are my five key takeaways from this year’s final word on our social insurance programs.

- Imminent collapse nowhere in sight. Social Security and Medicare face long-term financial problems, but there’s no cause for panic about either program.

Social Security’s retirement program is fully funded for the next 19 years. It has $2.8 trillion in reserves, and that figure will rise to $2.9 trillion in 2019, when the surplus funds will begin depleting rapidly as baby boomer retirements accelerate. Although you’ll often hear that Social Security spends more annually than it receives in taxes, the program actually took in $32 billion more than it spent last year, when interest on bond holdings and taxation of benefits are included.

The retirement trust fund will be depleted in 2034, at which point current revenue would be sufficient to pay only 77 percent of benefits - unless Congress enacts reforms to put the program back into long-term balance.

Medicare’s financial outlook improved a bit compared with last year’s report because of continued low healthcare inflation. The program’s Hospital Insurance trust fund - which finances Medicare Part A - is projected to run dry in 2030, four years later than last year’s forecast and 13 years later than forecast before passage of the Affordable Care Act (ACA).

In 2030, the hospital fund would have enough resources to cover just 85 percent of its expenditures. (Medicare’s other parts - outpatient and prescription drug services - are funded through beneficiary premiums and general revenue, so they don’t have trust funds at risk of running dry.)

momentum investing

A massive academic study looking at the transaction data generated by individual investors over the past two decades basically shows that small traders tend to engage in trades that contribute to momentum returns. The same analysis if applied to the transaction data generated by large institutional investors shows that institutional investors tend to react more appropriately to gains and losses.

Essentially the individual traders are contributing to the returns generated from a momentum-based investment strategy. Basically, stocks that have the greatest ownership by individuals as opposed to institutions tend to show the strongest profits in response to momentum trading strategies.

Now, if it were the case that individuals contributed to momentum returns by behavioral biases, we would expect to see stocks with low volume - which would be more likely to be held by individuals - to exhibit stronger momentum returns. This is exactly what the data shows.

Basically, if you are going to buy momentum stocks, you want to buy those that are owned primarily by individuals as opposed to institutions. The straight-forward reason is that individuals are more governed by their psychology than institutions. As a result, individuals tend to become more risk averse when a stock rises in price and are likely to sell too early. This means that those stocks that have appreciated dramatically in price over the past months are poised to go even higher as they have been unduly sold by individuals who have become risk averse.

Additionally, there is good evidence that over the past seventy years, momentum strategies seem to work much better in periods of economic expansion. Generally speaking, momentum strategies do not work well during recessions and at the turning points when the economy shifts from an expansionary phase to a recessionary phase or vice versa.

If you take a step back and think about it, this makes logical sense. During an expansion, the stocks exhibiting the most momentum will be those which are benefiting the most from the expansion. These stocks will tend to be the most cyclical stocks, and those that will be hit the hardest if the expansion disappoints and the economy begins to contract. Keeping that in mind, if you are going to employ a pure momentum strategy, you must always keep one eye on the economy. If there is a whiff of a recession, you need to be transitioning to more of a value-driven strategy.

-- Mitch Zacks, ZIM Weekly Update     

Where your Dollars Go

Americans today spend their money on the same things they always have, including housing, health care, transportation, food, and entertainment. But while what we spend money on has stayed essentially the same in recent decades, how that spending is distributed has changed in significant ways. In 1952, health care costs made up just 5% of Americans’ annual spending.¹ But health care costs have risen substantially over the decades, partly due to the increased cost of advanced medical technology.

Meanwhile, improved efficiency in production and manufacturing methods pushed down the cost of food and clothing. In 1952, Americans spent more than 40% of their income on what they wore and what they ate. Sixty years later, those categories made up just 17% of household spending. At the same time spending has been reduced on food and clothes, the amount spent on financial services and insurance has more than doubled between 1952 and 2012.

                             1952 1972 2012
Food                          29%  21%  14%
Housing                       16%  18%  18%
Health Care                    5%   9%  20%
Transportation                11%  13%  10%
Clothing                      11%   8%   3%
Financial Services/Insurance   3%   5%   7%
Recreation                     6%   7%   9%

-- T. Rowe Price Investor, June 2014

Bill Bernstein

In 2000, Bill (not Peter) Bernstein published his first book, The Intelligent Asset Allocator. It yanked away the punch bowl from the New Era's party. While other investment publications (most notably, the best-seller Dow 36,000) advocated euphoria and heavy doses of then-popular growth stocks, The Intelligent Asset Allocator preached the unfashionable virtues of diversification, caution, and contrarianism. Among its recommendations were REITs and gold stocks. It was, in short, a hopeless cause--the rare investment tome that sold what would succeed, rather than what had already thrived. Obscurity beckoned.

This summer, Bernstein published a sequel: Rational Expectations: Asset Allocation for Investing Adults. Much of the material--the basics of Modern Portfolio Theory, asset allocation, and the efficient-market hypothesis--is familiar, although freshly presented. The changes interested me most, however. They addressed my favorite investment question (typically aimed at fund managers, but applicable to authors as well): What have you learned since you started in the business?

Bernstein writes, "As Warren Buffett famously observed, investing is not a game in which the person with an IQ of 160 beats the person with an IQ of 130. Rather, it's a game best played by those with a broad set of skills that are rich not only in quantitative ability but also in deep historical knowledge, all deployed with Asperger's-like emotional detachment."

In fact, continues Bernstein, being extremely bright and technically accomplished can actually be detrimental to investment performance. As with prom queens, who overstate the importance of beauty, the quantitatively adept will sometimes overestimate the value of their own gifts. The geniuses at Long-Term Capital Management, for example, had rather too much faith in their ability to outsmart the marketplace and rather too little recognition of the possibility that they might be wrong. Bernstein suspects that many of his readers may fit a similar profile and pleads with them to "fill in what may be the shallow areas ... a working knowledge of financial history and a healthy dollop of self-awareness about [their] discipline under fire."

Put another way, a powerful mindset is at least as important for investing success as is a powerful mind. This realization did not come immediately to Bernstein because the mindset came naturally to him. He was willing to follow what the data suggested, regardless of how his actions looked to others, and regardless of whether the market seemed to agree--even if the market's disagreed for several years. (As with other contrarians, Bernstein spent much of the late 1990s doubling down on losing value stocks, and looking ever more foolish in doing so.)

Most people, however, are wired differently. In Rational Expectations, Bernstein painstakingly explains what was mostly implicit in his first book: Emotions destroy investment performance. Somehow, some way, investors must suppress them. The suppression might come from the blessing of nature; from ongoing investment education; through shielding mechanisms such as holding a blind trust; or, most commonly, by cutting back on stocks and holding a lower-volatility asset allocation. One way or another, though, it needs to happen.

Paradoxically, writes Bernstein, the task is hardest for people who are otherwise admirable. He states, "The most emotionally intelligent and empathetic people I know tend to be the worst investors. After all, the very definition of 'empathy' is to feel the emotions of others, which is deadly in investing." Bernstein relays the story of hospital patients who have brain lesions that disconnect their sense of fear; in investment simulations, those patients handily outperform the general population. For most people, investing successfully is a deeply unnatural act.

still big after all these years

Of the 10 largest companies in the S&P 500 Index in terms of market capitalization in 1992, five still retain that position (ExxonMobil, AT&T, IBM, General Electric, and Procter & Gamble). The other five have been replaced by Apple, Microsoft, Google, Chevron, and Johnson & Johnson.

Mr. Puglia: History will tell you that change occurs and the leadership of the market changes accordingly. It has been very difficult for companies to sustain dominant positions. But it’s much more difficult to sustain leadership in the technology area where companies are subject to shorter product life cycles.
I think it’s noteworthy that IBM has been able to maintain its leadership, and the reason is that it has been strong in services and software rather than being solely subject to product life cycles. It’s also a little easier for companies in staples, such as Procter & Gamble, to maintain leadership over time.

Mr. Berghuis: I was surprised that five of the top 10 are still there. It shows that there is more stability and persistence in our economy and in corporate America than perhaps is commonly perceived.
Our economy is evolving, but that’s not to say that if you invest in a blue chip company today it won’t still be a reasonably vibrant company a generation later if it is well managed.

-- T. Rowe Price Report, Winter 2013

Looking at ETF Database, the other five in 1992 were Wal-Mart, Philip Morris, Coca Cola, Merck, Royal Dutch Petroleum, Bristol-Myers Squibb.  Wait that's six.  IBM is not in their list.

And they have Pfizer instead of Google in 2012.

Apple appeared on the list in 2009 at #5.  Went to #2 in 2010 behind XOM.  Then surpassed XOM in 2012.

Checking the ETF Database, I'm surprised how much the top ten changes every year.  Three of the top ten changed in 2013, 2012, 2010, 2009, 2007.  Five of the top 10 from 2006 are no longer in the top 10.  And the only stocks to remain in the top ten every year since 2006 are XOM, MSFT, PG.

opposite directions

Main Street and Wall Street are moving in opposite directions.

Individual investors are plowing money back into the U.S. stock market just as professional strategists say gains for this year are over. About $100 billion has been added to equity mutual funds and exchange-traded funds in the past year, 10 times more than the previous 12 months, according to data compiled by Bloomberg and the Investment Company Institute.

The growing optimism contrasts with forecasters from UBS AG to HSBC Holdings Plc, who say the stock market will be stagnant with valuations at a four-year high. While the strategists have a mixed record of being right, history shows the bull market has already lasted longer than average and individuals tend to pile in at the end of the rally.

"If Wall Street, after poring over all known data, comes up with a target and we're already there, and you still see individual investors buying and they're typically the ones that are late to the party, it would seem there is limited upside," Terry Morris, a senior equity manager who helps oversee about $2.8 billion at Wyomissing, Pennsylvania-based National Penn Investors Trust Co., said in a July 8 phone interview.

For most of this year, equity investors have seen little volatility and steady gains, giving them confidence to put money back into the market. Individuals deposited about $9.5 billion in June to stock funds and have added cash in eight of the past 10 months, data compiled by ICI and Bloomberg show. That's a reversal from the five years through 2012, when $300 billion was withdrawn.

Professional investors, such as Nick Skiming of Ashburton Ltd., say that individuals investors are attracted to stocks after seeing others getting rich from a big rally, a time when equities are usually overpriced. The bursting of the technology bubble in March 2000 was marked by mutual funds absorbing a record $102 billion in the first quarter.

"As institutional investors, we're always concerned when the retail investor is actually arriving in the market," Skiming, who helps manage $10 billion at Ashburton, said by telephone from Jersey, the Channel Islands. "The retail investor arrives when they can only see blue skies."

For Laszlo Birinyi of Birinyi Associates Inc., stocks have entered what he calls the exuberance phase, the last of four stages usually seen in bull markets. He still sees more gains to come, citing the skepticism on Wall Street as a sign that plenty of investors haven't bought shares yet.

Relatively expensive valuations will also limit future gains, according to Garry Evans, HSBC's global head of equity strategy in Hong Kong. He said in a report last week that the S&P 500 will finish the year at 2,000, a 1.6 percent gain from last week's close. The index trades at 16.6 times projected earnings, near the highest level in four years, data compiled by Bloomberg show.

The bull market, which has almost tripled the S&P 500's value since 2009, is closer to the end than the beginning, said Walter Todd, who oversees about $980 million as chief investment officer at Greenwood Capital Associates LLC. The rally has lasted 64 months, about a year longer than average, according to data since 1962 compiled by Birinyi and Bloomberg.

"To the extent that investors start to put a lot of money into the market, it would certainly be late," Todd said in a July 9 phone interview from Greenwood, South Carolina. "But to say that the end is going to happen in the next few months, I don't agree with that."

empty floors

UBS AG's trading floor in Stamford, Conn., once teemed with traders occupying a space equal to two football fields. The Guinness World Records recognized it as the biggest such facility on the planet. And the Swiss bank used it to showcase its Wall Street credentials.

Stu Taylor, a former UBS managing director in trading who now runs trading-technology company Algomi Ltd., remembers when guests were brought around the gallery regularly. "It was very much a showpiece," he said.

Today, there are virtually no traders shouting into their phones or staring at terminals. UBS's cavernous floor is taken up mostly by back-office, legal and technology staffers, according to people familiar with the bank.

A spokeswoman for UBS said the trading floor was built for 1,400 traders, but wouldn't disclose the number of employees at the facility.

A deep slump in trading activity in everything from stocks and bonds to currencies is changing the face of Wall Street. Businesses that once contributed disproportionately to the revenues of the world's largest banks are now bleeding jobs and sparking fears of a permanent decline.

Today's markets are "boring," said Thomas Thees, a former head of North American credit trading at Morgan Stanley and a former co-head of fixed income at Jefferies Group. "This is affecting the opportunity to make money, and ultimately the earnings these [trading] businesses can provide."

Global revenue from trading in fixed income, currencies and commodities, or FICC, dropped to $112 billion last year, down 16% from a year earlier and 23% from 2010, according to Boston Consulting Group.

As big banks with large trading operations such as J.P. Morgan Chase & Co., Goldman Sachs Group Inc. and Citigroup Inc. report second-quarter earnings results this week, investors and analysts will be trying to find out whether the slowdown is a temporary funk or a lasting shift.

The forces arrayed against banks' trading businesses are powerful. Since the financial crisis, regulators have limited their ability to take risks with their own money, and have made the process costlier, prompting many to dial back or push in different directions. At the same time, global markets have fallen into an unusually placid pattern that has damped clients' desire to make trades.

"It's been absolutely dead," said Jarrod Dean, a municipal-bond trader at Sierra Pacific Securities in Las Vegas. Municipal-bond trading volumes are down about 30% since last August, he said, while profits are down more than 70%. "We've just got to keep toughing it out," he said.

waiting for the correction

The long bull market in the United States remains intact but there have been some recent stumbles. We would like to see some further selling in order to correct some of the overly optimistic sentiment (a contrarian indicator) that's built up. The Ned Davis Research Daily Crowd Sentiment Poll recently hit its most optimistic level since the end of last year, near levels that have typically preceded a relatively decent pullback.

Additionally, midterm election years (like 2014), have historically brought decent-sized pullbacks in each year going back to 1962—ranging from -8% to -38% with the average decline being -19% (thanks to Strategas Research Partners), but those pullbacks have been followed by substantial rallies over the subsequent 12 months, ranging from 12% to 58% and averaging a whopping 32%.  We haven't seen that type of pullback yet, and history doesn't always repeat, but it does often rhyme.  Bottom line—in our view the possibility of correction is elevated, but we would view such an occurrence as a buying opportunity for those who have been under allocated to equities.

Valuations are being debated, with concerns about overvaluation growing—exacerbated by comments from the Fed related to biotechnology and social networking stocks.  Given continued low interest rates and inflation, the market can likely maintain higher valuations, and current levels are roughly inline with where history has shown they should be.  So while the market is no longer a significantly undervalued story, we don't believe valuations have become an impediment to this bull market.

-- Schwab Market Perspective, July 18, 2014

A brief history of Social Security

Living beyond one's productive, working years is a recent development in human history. Formal programs offering "social insurance" for the elderly were only proposed when people started, in greater numbers, to live beyond their ability to work effectively.

Until the 1840s, the U.S. was primarily an agricultural society in which the majority of people lived in rural areas. Extended families took financial responsibility for older members. But over the next five decades, technology advanced and the lives of workers changed dramatically—and life spans began to rise. Machines set the pace of work. Industrial output consistently outpaced agricultural output.

With better sanitation and health care, life spans increased a full 10 years in just the three decades between 1900 and 1930. By 1920, for the first time in the nation's history, more people lived in cities than on farms, fraying the support system of the extended family. The Great Depression made older Americans' work situations even more challenging—over half of the country's elderly couldn't support themselves.

On August 14, 1935, recognizing the need for federal assistance, Franklin D. Roosevelt signed the Social Security Act into law.

-- T. Rowe Price Investor, March 2013

why you invest the way you do

People like to assume they can think objectively. But you and I are just a product of the experiences we've had in life.

In 2006, Ulrike Malmendier of U.C. Berkeley and Stefan Nagel of Stanford University looked at how various cohorts of Americans differed in their views about investing.

Controlling for age, wealth, income, and other social factors, how the economy performed during people's young-adult years had a profound impact on how they invested later in life.

Those who grew up during the Great Depression were half as likely to invest in stocks as adults compared with those raised during the roaring 1960s. Those who grew up during the inflationary 1970s were less likely to invest in bonds later in life than those raised during the stable 1950s. Growing up during the prosperous 1980s made you highly likely to favor stocks during the 1990s. "Our findings suggest that individual investors' willingness to bear financial risk depends on personal history," the authors wrote.

This seems obvious, but there's an important takeaway: One person's view of risk can be completely different than someone else's. And not because one person is smarter or has better insight than another, but simply because they were born in a different year.

Emotional experiences also have a downside: Memories are often distorted, so much so that some of what we remember never actually occurred.

For decades, psychologists have interviewed people who had an emotional experience, sprinkled in some fake prompts, and watched their memories fool them on the spot. In one famous example, Lawrence Patihis of U.C. Irvine discussed 9/11 with a group of research subjects, and found that, when prompted, many could vividly describe seeing video of Flight 93 crash into a field in Pennsylvania (this video, of course, doesn't exist). "It just seemed like something was falling out of the sky," one participant said. "I was just, you know, kind of stunned by watching it go down." They weren't lying. This is a common flaw when recalling emotional experiences, as we try to forget painful memories and replace them with pleasant thoughts.

If someone's view of risk is influenced by what year they were born, and people's memories of emotional events may not even be accurate, there's an obvious lesson: When seeking advice, you should consult a variety of different people of different ages and backgrounds who have experienced different things in life.

This isn't a substitute for skill. But if you get all of your investment advice from 50-year-old white guys, you will get opinions from people whose worldview is colored by similar experiences. And those experiences may be incomplete, not relevant to today's world, and biased in thinking the future will resemble their specific past.

A common trait you'll see among the world's best investors is an open and flexible mind. They are happy to hear diverse opinions from people of all different ages and backgrounds. This isn't because they're nice, but because they understand everyone is biased to their own experiences, and that no group has a monopoly on wisdom. Think about the last five years, when lots of angry old men were hyperventilating about looming hyperinflation and the coming collapse of the dollar, while a bunch of college kids who were "ignorant of history" were busy building billion-dollar tech companies. Not being constrained by past experiences can be incredibly valuable.

selling too soon

For growth investors, a cardinal sin is missing a successful growth company, such as Wal-Mart, Microsoft, or Apple, early on. But giving up on one too soon, due to a short-term concern, can be almost as painful.

Jack Laporte, who managed the small-cap New Horizons Fund for 22 years and has more than three decades of investment experience, recalls investing in Starbucks when the company went public in 1992. He sold it about two years later due to concerns about a spike in coffee costs cutting into profits. It was a good call at the time because the costs did rise and the stock stagnated for months.

While Mr. Laporte made a nice gain, the company’s later success made him regret the sale. He calculated that by 2006 the fund’s original position in Starbucks would have been worth an Benefiting From Mistakes Even the Pros Have Made additional $200 million.

“I outsmarted myself by trying to trade around a unique company, and that was a very expensive lesson,” he says. “It’s hard enough to find truly great companies like Starbucks with open-ended growth opportunities. When you find them, don’t get caught up in short-term valuation issues if they are growing rapidly.”

-- T. Rowe Price Report, Fall 2011

The best investment advice of all time

Billionaires. A miser. A Nobel laureate. A Founding Father. We've rounded up the finest market minds -- dead or alive -- and distilled their timeless wisdom into specific suggestions for stocks, bonds and funds you can buy today. Be warned: You just might get rich.

Read through this slideshow for timeless investment advice from 10 of the world's finest financial minds.

Jack Bogle: "Don't let the miracle of long-term compounding of returns be overwhelmed by the tyranny of long-term compounding of costs."

Sir John Templeton: "If you buy the same securities everyone else is buying, you will have the same results as everyone else."

Warren Buffett: "Whether socks or stocks, I like buying quality merchandise when it is marked down."

Nathan Mayer Rothschild: Information is money

Sam Zell: "Look for good companies with bad balance sheets and understand your downside."

Joseph Schumpeter: "A depression is for capitalism like a good, cold shower."

Peter Lynch: "Everyone has the brainpower to follow the stock market. If you made it through fifth grade math, you can do it."

Alexander Hamilton: "A nation which can prefer disgrace to danger is prepared for a master, and deserves one."

David Tepper: "I am the animal at the head of the pack. . . . I either get eaten, or I get the good grass."

Hetty Green: "All you have to do is buy cheap and sell dear, act with thrift and shrewdness, and be persistent."

Buffett's biggest secret: cash

Warren Buffett has gone into every economic recession with an excess of cash on the balance sheet. In these recessionary periods, the average company is trying to shore up assets and deleverage. That's when Buffett swoops in and buys companies for pennies on the dollar. Plus, because Berkshire Hathaway has excess cash and no debt, he doesn't have to deleverage. He can use ongoing operating profit from his business to buy other businesses, rather than use retained cash to increase the size of his cash pile.

Financial advisers will often tell clients to dollar-cost average even through a financial panic. However, most investors won't follow that advice. Because they don't want to buy low, they consistently lose money to people like Warren Buffett, who consistently buys low and sells high.

When investors buy Berkshire Hathaway stock, they buy into a CEO who has the right temperament for managing money.

The Loser's Game

There are two types of games: "Winner’s Games" and "Loser’s Games." Now this doesn’t mean that losers play only certain games, while winners play other games. It has nothing to do with personality characteristics. By "Loser’s Game," I don’t mean that investors are losers. It is just a way to classify games to help us understand them better.

The outcome of any competitive game depends upon the actions of both the winner and the loser of the game. This does not always imply the winner’s actions will dominate the outcome. Many games are not won, but rather, are lost. It is important to understand the distinction.

Winner’s Games are those games whose outcome is largely determined by the actions of the winner. Loser’s Games are those games whose outcome is largely determined by the actions of the loser.

Amateur tennis is a loser’s game. Non-highly-trained players do not possess the skills to deliver excellent serves and returns with consistency. An attempt to try harder to deliver superior shots, compared to the opponent, will not meet with success, but double faults and shots that go out of bounds. Trying harder to make great shots will mean that you are giving the opponent points. The player is not only competing against the other player, but also against the inherent difficulties of the game. The more competitive the amateur tries to be, the more the inherent difficulties of the game will beat him down.

The amateur who has not mastered the fundamentals of the game is far better off just trying to deliver a shot within the tennis court bounds than trying to outplay the opponent. Keep the ball in play and give the opponent the opportunity to mess up the shot. And, the harder the opponent tries, the more likely he will mess up!

If you were playing a professional tennis player, the situation would change drastically. Professional tennis is a winner’s game. Professional tennis players have mastered the fundamentals of the game. You must not only master the fundamentals of the game to win, but you must also deliver superior shots. You must outplay your opponent to win. Returning the ball within court bounds is not enough. The opponent probably won’t mess up and might well force a shot you can’t return.


Investing is a loser’s game. It is a loser’s game, not only at the amateur level, but also at the professional level. Over time, trying harder to achieve superior returns will usually lead to inferior returns. Trying to time the stock market, day trading, buying options, and most active investment advice approaches investing as though it were a winner’s game—believing you can actually conquer and beat the market.

If, for example, you had felt that the stock market was overvalued and due for a correction, and you had remained out of the stock market for the year 1995, you would have missed one of the market’s best years ever. But, maybe, you also missed the big market drop of 1987. What could you conclude from this? Probably, as with my streak of tennis losses, you would tend to remember the victories (or, near victory shots that led to losing the game!) and forget the defeats.

You reason that if only all your tennis shots or investment decisions had been as great as the best ones you remember, you would have won decisively! But, seeking that one great shot is what cost you the match.

You would tend to explain your victory as confirming proof of market timing and your skill to do it, while the defeat would be interpreted as only indicating a need to improve your methods slightly! You are interpreting investing, and more specifically, market timing, as though it were a winner’s game. It is not! It has never been shown that anyone, I repeat anyone, can master stock market timing.

Looking for stocks you feel might go up ten or twenty times from their present price in a few short years is also a form of trying to invest in the stock market as though it were a winner’s game. Or, given the late 1990’s you might be seeking growth stocks that go up 100 times or more in a few short years!

After all, you recall Dell, Cisco, Yahoo, and other companies which shot up by amazing amounts. To buy such speculative stocks implies you feel confident in finding opportunities that are grossly misevaluated by the market. Usually, you will not invest in the next Dell or Cisco, but, rather, the next He-Ro apparel company of the day. That is to say, a lousy investment. This can lead to huge losses.

Individual investors usually have not mastered business evaluation and fundamental analysis sufficiently to actively select the very best aggressively-chosen stocks from among the larger market. But don't feel bad. The professionals who are paid millions of dollars haven't done much better.

Understanding that investing is a loser’s game at heart should keep you from trying to force too many shots. Rather than looking for one big winner, aim for consistency in your results. The bulk of an intelligent investor’s portfolio should be invested in high-quality, larger companies purchased at reasonable prices. Such a portfolio will likely beat, not only a market timer’s portfolio, but also a speculative portfolio of "carefully" selected, aggressive stocks on a risk-adjusted basis.

[This seemed familiar.  Looking in my copy of The Investor's Anthology, this article looks like a rip-off (or adaptation) of The Loser's Game by Charles Ellis.  Ellis also apparently wrote a book around the article called Winning the Loser's Game, now in it's sixth edition.]

add to stocks in retirement?

Benz: You have done some research. You co-authored a paper with professor Wade Pfau where you looked at what equity allocations should look like in retirement. And your research came up with a somewhat counterintuitive finding, where you actually suggested that equities should trend up as someone goes further in retirement. Let's talk about your general findings and why you think that this is maybe something that retirees should look at?

Kitces: Certainly the reactions to some of the research that we've done have been interesting at the suggestion that maybe equities should actually glide upward and you would get a little bit more aggressive through retirement.

We see a natural retiree bias toward that anyways. We don't really want to own any more equities than we have to. [They can be] a little volatile and a little scary. And we've had this kind of rule of thumb for a very long time of "Own your age in bonds, or 100 minus your age in stocks," all of which gets you to the same point. As you're getting older your equity exposure declines and that was a way to own fewer equities through retirement.

The problem is that particular approach where you decrease them over time, psychologically I think there is some comfort to it. Unfortunately from the research, it just doesn't work very well. [Financial expert] Bill Bengen did some work on this back in the late 1990s after he had done his initial safe withdrawal-rate research and found that decreasing equity exposure through your retirement hurts; you got lower income and withdrawal rates. Not a huge difference if you only did a little bit of trimming, but you got lower outcomes.
David Blanchett, Morningstar's head of retirement research, did a wonderful study on this six or seven years ago where he tested something like 43 different versions of decreasing equities--so you decrease by little a year or a lot every year, or a little bit and then more, or more and then a little bit--all the different ways that we could glide that equity exposure down. And basically what he found was just sticking with the same balanced portfolio and rebalancing to it worked better than all of these decreasing-equity-exposure approaches.

What Wade and I did was really just kind of take it one step further and ask, "If starting [with higher equity allocations] and coming down doesn't work very well and starting [at one level of allocation] and sticking [with that same level of allocation over time] goes better, what would happen if we started lower and glide it back up to where we were going to be in the first place?" So we'll own less in equities early on and will maybe end out with a portfolio that we would have held throughout anyways. So, if I were going to be 60%-40% in retirement, we're never going to go higher than 60%, but rather than being 60% equities every year, what if we went down to 30% in equities and then started gliding back up toward that original 60% target. And what we found was it actually works.

One of the key things to note about that coming right out of the gate, though, is equities would be gliding upward through retirement, starting from a much more conservative point. While a lot of the discussions around this have been framed as "How aggressive is it to be adding equities for people through retirement?"--what we were actually finding is that this is a strategy to give you lower equities in retirement, lower average equity exposure overall, just doing it in a manner that works a little bit better.

how rich people think

According to Steve Siebold, what separates the rich from the rest of us isn't so much what they do.

It's how they think.

Siebold spent nearly three decades interviewing millionaires around the world, and boiled his findings down in "How Rich People Think," a book he describes as "so brutally honest it will shock some and inspire others." 

In it, he touches on everything from beliefs about the root of all evil to faith in what drives the financial markets and what parents should teach their children to set them up for financial success.

[for example]

Rich people believe in acquiring specific knowledge

... while average people think the road to riches is paved with formal education.

"Many world-class performers have little formal education, and have amassed their wealth through the acquisition and subsequent sale of specific knowledge," Siebold writes.

"Meanwhile, the masses are convinced that master's degrees and doctorates are the way to wealth, mostly because they are trapped in the linear line of thought that holds them back from higher levels of consciousness ... The wealthy aren't interested in the means, only the end."

Rich people believe you have to be something to get rich

... while average people believe you have to DO something to get rich. 

"That's why people like Donald Trump go from millionaire to $9 billion in debt and come back richer than ever," Siebold writes. 

"While the masses are fixated on the doing and the immediate results of their actions, the great ones are learning and growing from every experience, whether it's a success or a failure, knowing their true reward is becoming a human success machine that eventually produces outstanding results."

Rich people would rather be educated than entertained

... while average people would rather be entertained than educated. 

While the rich don't put much stock in furthering wealth through formal education, they appreciate the power of learning long after college is over, Siebold explains.

"Walk into a wealthy person's home and one of the first things you'll see is an extensive library of books they've used to educate themselves on how to become more successful," he writes. "The middle class reads novels, tabloids, and entertainment magazines."

[and more]

the most important metric

What is the most important metric tied to stock performance?

The complexity of the investment field makes it difficult to ever determine a “right” answer to this question. Benjamin Graham’s exploration in ‘The Intelligent Investor’ was the first work to provide convincing answers. But the 80 years following the book’s release have seen thousands of ever more complex theories and models all trying to answer this same inherent question. From the Nifty Fifty to the Dogs of the Dow to The Little Book That Beats the Market, it seems like everyone has offered a simple solution that
temporarily outperforms.

Wall Street has of course taken it several steps further with stock-correlation algorithms, momentum trading systems, and multi-variable back testing. But their long history of excessive fees and embarassing underperformance leaves little envy for their methods – at least in the minds of sophisticated investors. As value investors, we are wise enough to know that additional complication does not result in superior results.

But given the amount of data and calculation we are now able to perform, it makes sense to re-visit this age old question and finally produce a definitive result.

Two works of research will be referenced in this article. The first is by in-house GuruFocus analyst Vera Yuan. Her article, ‘Earnings, Free Cash Flow, Book Value? Which Parameters Are Stock Prices Most Correlated To?’, examined the stock price correlation to eight fundamental metrics across a full business cycle.

The picture here couldn’t be much clearer. When it comes to banking, investment and other financial stocks, book value is king. Book and tangible book were the consistent winners here across all four market periods.

Non-financial stocks produced similar results, albeit less overwhelmingly than the previous group.

However, one research study is not a sufficient basis from which to base our entire investment philosophy.

The second test for the validity of book value superiority was constructed by Tobias Carlisle of Greenbackd. He back tested this topic using 87 years of equity data in ‘Investing Using Price-to-Book Value Ratio or Book Equity-to-Market Equity Multiple (Backtests 1926 to 2013)’.

Carlisle’s research examined book value to stock price correlations back to 1926. Using a 3,715 stock sample with complete financial data, stocks were grouped into a value decile representing the 459 lowest price-to-book multiples and a glamour decile containing the 404 highest multiples. Unsurprisingly, the value group outperformed the higher multiple glamour group for the period.

***

Looking at my copy of What Works on Wall Street, "Over the long term, the market rewards low price-to-book ratios and punishes high ones.  Yet the data show why investors are willing to overlook high price-to-book ratios -- for 20 years, large stocks with high price-to-book ratios did better than the Large Stocks universe.  A high price-to-book ratio is one of the hallmarks of a growth stock, so high price-to-book ratios alone shouldn't keep you from buying a stock.  But the long-term results should caution you against the highest price-to-book ratio stocks.

Buffett's Alpha (again)

In their paper Buffett’s Alpha, Andrea Frazzini, David Kabiller, and Lasse Heje Pedersen analyzed Buffett’s returns from 1976–2011 and decomposed them to identify the primary factors driving Buffett’s significant alpha. For regular followers of Buffett, the results should come as no surprise, but let’s dig in and discuss the three primary sources of Buffett’s alpha …

In summary, the authors regressed Buffett’s returns against factor exposures commonly known to influence returns. The three factors that showed as significant are forehead-slappingly obvious.

• Value: Buffett has a tendency to favor low price-to-book value stocks.
• Safe: He bets against beta in that he favors low beta stocks.
• Quality: Finally, he favors quality companies (profitable, growing) over junky companies.

Which brings me to my take-home point: Investing is simple, but it is never easy. Warren Buffett (Trades, Portfolio) identified early on in his career the value investing tenets that would guide his investing career. He then had the audacity to apply those concepts year in and year out regardless of what was happening in the world around him.

Buffett’s worst years were at the height of the TMT bubble when the market saw his way of investing as out of date and not fit for this “new era” of investing. (Side note: Whenever something is said to be in a “new era” or of a “new paradigm,” do yourself a favor and short the ever-loving shit out of those securities—it’ll be like winning a rigged lottery because all those words really mean is “BUBBLE!” and bubbles always burst).

Despite this external pressure, Buffett stuck to his process and made an absolute killing in the tech wreck years that followed. Being a value investor often means you are taking a contrarian view by definition, which can be hard for humans. We are hardwired to take our social cues from the herd, so maintaining an opposite view requires determination and guts.

Do your homework better than the other person, stick to your process, and you too can tilt the odds in your favor.

[see also Buffett's Alpha]

Millionaire Mistakes

In a recent survey, high net-worth clients (those with more than $1 million in assets) were asked about their top five investing mistakes. Not surprisingly, some of these are ones that everyone faces, regardless of net worth. Some of these mistakes can be very costly, making the difference between financial dependence and financial independence.

Here are the top mistakes and what you can do about them.

1) Failing To Diversify. Almost a quarter of millionaires said their top investing mistake was not diversifying enough. No matter how much you make, diversifying is crucial to investment success. Karl Eller was a founding investor in the Phoenix Suns, built a successful advertising business and was head of Columbia Pictures. He invested almost his entire net worth on purchasing the convenience store chain Circle K. Under his leadership, it grew considerably, but he failed to diversify. When Circle K declared bankruptcy in 1990, he lost close to $1 billion and left with almost nothing. In an interview with Tony Robbins, he mentioned that lack of diversifying was the biggest mistake he made. Spreading your investments around is one of the best ways to manage and lower risk. It has to be done correctly. Diversifying only is helpful if each different investment has a different risk profile. Spreading your money around different tech stocks is not the same as spreading it around different industries. If the tech industry takes a hit, the other industries may bolster your investment portfolio.

2) Investing Without A Plan. If you fail to plan, you will plan to fail! Investing without a plan is gambling — 22 percent of millionaires regret not creating an investment plan. A good plan will help you set goals, choose the right type of investments and stay disciplined. Studies show that people with an investment plan will outperform those who do not. Visit artofthinkingsmart.com for sample plans.

3) Making Emotional Decisions. About 20 percent stated that emotional investing decisions have been their biggest mistake in the past. Emotional investors buy when things are going well and sell when things are going bad. This is the opposite of what they should be doing. Sticking to your plan and working with a financial adviser will help prevent emotional decisions.

4) Failing To Review A Portfolio. Sixteen percent said they failed to regularly review their financial plans and portfolios. As the market changes, investors should review and rebalance on a regular basis. As your goals, time horizon and risk changes, you will need to adjust your investments to be in line with your updated investment profile.

5) Fixating On Previous Returns. Fourteen percent said they relied too much on historical returns and not enough on future expectations. Just like an athlete who may have had a good season in the past, it doesn’t necessarily mean he or she will do well this season. It can be one criteria, but it should not be the basis of your investment decision. Studies have shown that many mutual funds that were in the top percentage of their category were in the lower performance categories later on.


david@artofthinkingsmart.com