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On the market and other Friday notes. October 10, 2008

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From Investopedia---Capitulation: In the stock market, capitulation is associated with "giving up" any previous gains in stock price as investors sell equities in an effort to get out of the market and into less risky investments. True capitulation involves extremely high volume and sharp declines. It usually is indicated by panic selling.

For those who are wondering it is now apparent that capitulation is what is going on at Wall Street this week.  When will it stop?  Don’t know!  But we do know that this is not a once in a lifetime occurrence.   Since WWII there have been 10 bear markets (greater than a 20% decline) in the S & P 500.  That averages out to one every 6 years or so.  The average decline was 31.5% in these bear markets.  Two (1973-74 & 2000-2002) were around 50%.  Currently we are at around a 41% decline.  This feels like it might be one of those 50% declines.  The point is that this is not unusual in any way unless it goes to -60%. 

The second point that this drop does not have a corresponding fundamental reason.  Bear markets are just as irrational as bull markets.  All those mathematicians who try to tell us the markets are perfectly rational are simply wrong, the markets have always been more emotional than based on fundamentals in the short run.  The long run they are correlated with profits, but bounce around irrationally on a day to day basis.

Here is a chart of the S & P 500 Index going back to 1950.  Looks pretty scary at the end, but that is a function of the scale.  In other words because of the growth the absolute numbers are much larger making it appear to be larger percentage drops at the end.  Changing it to a log base 2 scale (don’t worry about the math) allows our minds to make better sense of the proportion.

Now we see, that there are no unusual variations from this weeks drops!

However, the media does what it always does and makes it seem like the end of the world.

Here is a couple of sentence from my forthcoming book.

The truth is that several times a decade mutual funds drop over 20%. It was only 20
years between times that the S&P 500 dropped 50%. So we see big drops aren’t unusual for stock funds. Wall Street has sold mutual funds as a way to not have risk or at least avoid most of it. Now the truth is you must assume some risk in order to build wealth. Instead of that message, the message is that mutual funds diversification makes risk disappear. So is it surprising when individuals who are sold on an investment that has little risk, react badly when their funds lose value?

Yesterday, I pointed out that mutual fund outflows forces selling. Add in investor panic and you have the recipe for what has been happening! My best advice, build a plan that suits your personality and does not require unrealistic returns to find success.

Risk II; Systemic Risk September 30, 2008

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Following up on our discussion of strategic risk yesterday, we will discuss systemic risk today.

Systemic risk makes up the majority of what most investment folks consider risk. Very simply it is variance. It is the total margin, both positive and negative, of the possible rates of return. For a stock the possible negative is -100% or total loss of all capital and the possible positive is infinity.  A stock can go up as high as its cash flow allows it.  In more practical terms the total possible can be thought to be +500,000% (Berkshire Hathaway has gone up 400,863% in the last 43 years). So we can reasonably say that any stock has a variance of 500,100% (500,000% + 100%)!

Now we see why mathematicians think that any single stock is tremendously risky! Now as a way to deal with this risk, most investment professionals suggest diversification. What diversification does is truncate the possible rates of returns. For example, if you own 20 stocks it is highly unlikely that all 20 will go out of business. It is also highly unlikely that all twenty will return anywhere near what Berkshire Hathaway did. So we can say with a good degree of certainty that the negative possibilities decrease from -100% to -80% and the positive possibilities from +500,000% to +10,000% (The S & P 500 Index went up 6,840% in the same 43 year time period). So diversification decreases the possible variation of rate of returns from 500,100% to 10,080%. Quite a difference and why mathematicians were so impressed with diversification!

Now, I want you to look at the numbers again. The risk is uneven or skewed. The upside has much more potential than the downside. With diversification you really bring the upside potential down, but only reduce the downside potential by a little.

Warren Buffett does not believe in diversification as a strategy to reduce risk because of this skewed situation. He thinks one can pick companies that have good management, good cash flow, business plans that make sense, products or services that aren’t going out of style, and product or name recognition that creates a protective moat around the business. He has demonstrated he can pick good companies. There are many others that do the same thing, just not in a publicly owned company.

The key take-away from this post is to understand that systemic risk equals variance and that it is skewed toward positive results. Your fear of loss of all your money (as opposed to 80% of your money) is costing you much upside potential! My point isn’t to tell you not to diversify, but only to illuminate what it is costing you. Knowledge is king!

This 10 year chart of Berkshire Hathaway versus the S & P 500 Index I believe illustrates what I have been saying.  Note, the much tighter range for the S & P than Berkshire.  Berkshire has a much higher systemic risk (variance) than the diversified index!  However, the payoff for assuming this risk is in upside movement!

Next post we will discuss the non-mathematical aspects of risk!

Living in a post-fact world? September 21, 2008

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There have been much commentary and books written about how easy people find it to ignore inconvenient facts. “True Enough: Learning to Live in a Post-Fact Society” by Farhad Manjoo is a great account of this phenomenon.  Many, including this author, point their fingers at the web as starting this process.  However, I think it goes back much farther than this.  After all, scientists have always had their critics, long after their discoveries had moved from theory to established fact (Think Darwin!).

Currently, much of the critique is centered on politicians and voters.  Politicians lie and we don’t care seems to be the refrain.  OK, tell us something we don’t know!  But even more insidious is the constant bombardments of lies coming to us on a daily basis from industry.  I think if I have to look at another commercial from an oil company or domestic car manufacturer telling me they are really environmental friendly I will barf! 

So when I tell you that Wall Street is lying to you, many people will sluff that off as “tell me something I didn’t know!”  But, the point is that the lies of Wall Street are going to impoverish you when you can least afford it.  If I sound strident at times, it is because I know that you can do better with your finances.  It is because I know you can learn to differentiate financial fact from fiction.  On this Sunday morning before I take my son to Sunday School, I am going to repeat a chart from yesterday to drive home the point.  Once again, I am not a brilliant stock picker, nor lucky, only made a decision to look at facts instead of fictions!

 

For the last year, HCN up 25% (+6% dividends), Berkshire Hathaway up 10%, S & P 500 down 18%.

My portfolio up around 15% mutual funds down around 20%, a 35% difference!

Efficient Market? July 2, 2008

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For the last 40 years finance folks have been insisting that information on stocks is so wide-spread that is causes there to be a totally efficient market in the long term making it impossible for any one person to or fund to beat the market.  This has become the dominant theory leading to the idea that the individual investor should invest in stock index funds and concentrate on lowering expenses and asset allocation. John Bogle of Vanguard Investments created a family of funds based on this and has written books saying the same.  Ironically, Warren Buffett and Peter Lynch has joined in the noise of the efficient market.  Why ironically?  Because Mr. Buffett and Mr. Lynch are two people who beat the market for the length of their career rendering mind bending returns of over 20%.  Buffett for over 40 years and Lynch for 15 years (now retired). 

Enter in some historical accounts of financial bubbles throughout history, most recently real estate in 2003-2005 and technology stocks 1998-2000.  Confused yet?  I mean if markets are efficient, then what about market bubbles and how can a few select folks out perform the market for long periods of time?

Recently Mr. Buffet made a bet against a hedge fund manager, betting that a low expense index fund would outperform 4 hedge funds which have heavy expenses going to management.  The time horizon is 10 years.

Note that he didn’t bet on Berkshire, but on a stock index.

Market’s efficient?  Perhaps over the long run, but certainly not over the short term.  I define a speculator has one that tries to take advantage of the “madness of crowds.”  An investor is one that looks at the evidence, looks for value, and uses leverage when possible, to create higher returns.  As to Buffett; he is living proof that investors can outperform the market over the long haul.

I am betting on Warren Buffet being a better stock investor than I, so I put the majority of my stock portfolio in his hands.  So far it has worked out. 

I wonder what the stock index folks think about their efficient market theory now that we are staring down the possibility of a full decade of no growth from the S & P 500.  I have to admit I find these folks a little smug considering the reality of the evidence.  I mean I have had these folks tell me I am a fool for investing in real estate and an individual stock (Berkshire).  Yet, my home is worth over two times what I paid for it in 2000 and Berkshire has returned over 10% annually since 2000 and my REIT is up a total of 232% over the last five years in addition to paying out $12.34/share in that time.  Even my New Hampshire Condo bought in 2005 is up 10% in value.  Now I tell the reader all this not to demonstrate my superior investment skills, because I don’t have them.  Only to make the point that the market may be efficient, but that does not necessarily mean one should give up on the possibility of doing well and decide that average is the best you can do.  And for all those folks who think buying low expense mutual funds will get you to your goals, take a serious look at your finances now.  Time to learn how to do better!   

Efficient markets?  Who cares?????