Markets know best

It is not hard to come across investment opportunities that seem too good to be true. From the piece of real estate that can never fall in price because it is at a great location to the stock of a company that has great management so it will perennially keep appreciating are all "tips" that one often keeps hearing about. We also hear about the people who made a killing by actually investing in those. In this article, I will talk about when it makes sense to go by these tips and when it does not.

Efficient Markets

This is a technical term that actually is very useful to understand markets. Basically it says that the price of any item (including real estate and stocks) at any time is "correct". By correct it means that if you were to see the movement of price, it would increase in about 50% of the time decrease in 50% of the time. In other words, it is not possible, on an average to make profit.

How does it work?

While the proof and even the interpretation of this statement is very involved, some reflection will convince you that it should be correct. Consider the case of a property that is at a very good location. In this case, it may be the case that the property will be priced higher than others but why would it keep appreciating? On the other hand, if everyone knew it would appreciate than everyone would try to buy it and would make better and better offers to the seller. This would stop only when all the "excess appreciation" was factored into the price. Exactly the same thing works the company with a good product or a good management.

Can one make money out of tips?

A little reflection will tell you that the only way to make money out of tips like this is to get - and act on - them before others do. So your reaction may be to act on them immediately while others are still evaluating. This is often also mentioned in the tip itself. Unfortunately, that is unlikely to help you either.

The reason it does not work is because usually the person giving the tip has no special "love" for you. He could have given the tip to anyone else. Most likely, he chose the order in which to give the tip at random which means that a large number of people must already have received it and much of the price appreciation must already have taken place.

On the other hand, it is a great way to commit fraud. If even some people blindly believe on tips, than prices will increase for a short time. So the person giving those tips can hoard the item in question and sell it when the prices increase. This was the reason a why a couple of years ago promotional SMS about stock tips were banned.

But I believe in this tip

At times you will come across a tip that you think makes sense. Before investing on the basis of it, do ask yourself the following questions - 

1. What new information do I have that others either do not have or do not believe in?
2. Has there been any price movement in the last few days or weeks which may have been due to others getting the above information?
3. What is risk involved? What does it mean for my financial health?

When do markets NOT know the best?

This is one last thing that is important. There are a large number of cases when the market price may be wrong - often for large amounts of time. This often happens when

1. There is a monopoly - a single buyer or a seller.
2. Information is available to a select few - for instance when government comes up with a master plan for a city or a major contract is awarded.
3. Some new technology or innovation comes up - consider the dot com boom and bust
4. The world is going crazy - for instance when the central banks print a lot of money and flood the market with it

But in each of these cases again the only way you can make money is by getting out before everyone else realizes that they made a mistake. On the other hand, the potential to make huge losses is very large. If you realize that such a situation exists, the least that you should do is be very careful.

Five signs the investment article you are reading is B.S.

I keep getting emails from a particular contributor to Kiplinger's with headlines like '5 Reasons to Buy Gold Stocks', '5 Best Low-Risk Stock Funds' and '5 Great dividend-Paying Stocks to Buy -- Even Now'.  He used to be a Kiplinger columnist, but now is an independent investment advisor and uses the columns to generate business. I don't know why I even bother looking at such drivel, but apparently it's like a car-wreck that you can't help but look at.

The most recent one was so laughable I had to share.  It was titled "5 Formerly Top-Performing Mutual Funds to Sell in This Market'.  Here is some of the insightful writing:

Legg Mason Value - "Over the past five years, Value lost an annualized 9.4%, while Standard & Poor’s 500-stock index was roughly flat (all returns in this article are through December 6). Recent results have been so pathetic that they make Miller’s long-term record look like the work of an amateur."

Longleaf Partners - " Longleaf lost 64.8% in the 2007-09 bear market, compared with a 55.3% drop for the S&P index. Despite good performance since, the fund has lost an annualized 3% over the past five years and ranks in the bottom 10% among its peers for that period."

Bridgeway Aggressive Investors 1 - "The 2007-09 bear market was Bridgeway Aggressive’s Waterloo. It plunged 64.4%, 9.2 percentage points more than the S&P. Over the past five years, the fund lost an annualized 6.4%, an average of six percentage points per year worse than the S&P."

So these funds ruled the investment world, but in the last five years have tanked and now we should get out.  Thanks for that look in the rear-view mirror.  Might've been nice to have told us that BEFORE they crashed.

CGM Focus - "Over the past ten years, Focus returned an annualized 7.8%. That’s an average of 5.1 percentage points per year better than the S&P and good enough to place the fund in the top 1% among large-company-growth funds. He has beaten the market only twice in the past five years. Over that stretch, the fund lost an annualized 1.7%, including a 22.7% loss so far this year."

Fairholme Fund - "Over the past ten years, the fund returned an annualized 7.5%, an average of 4.8 points per year better than the S&P. But so far in 2011, it has tumbled 27.9%."

So if a manager underperforms significantly in one year dump him.  Apparently the recommendation here is to not think long term for your investments, but instead act on short term results.

In fairness, the author did say in 2010 he didn't like the direction manager Bruce Berkowitz was taking the Fairholme Fund.  But articles like this serve as reminders of the folly of active management and trying to beat the market.

The smart money still indexes.

Resilience in Military and Markets

It was eight years ago today (March 19 in the US, March 20 in Baghdad) that the bombing which initiated Operation Iraqi Freedom started.  When I recently read that I thought of the sacrifices and heroism of our men and women overseas and I'm grateful to live in the greatest country in the world.  Let's not think of our servicemen only on Veterans Day and Memorial Day - thank a soldier today.

In thinking of the significance of the war and how much time has passed since it started, I also thought of how significant the changes in our financial world have been over that same time.  When the war started we were coming out of the worst bear market since the early 70s and one that rivaled the Great Depression for the depth of market losses.  Since that time think about all the terrible things that have happened in the financial world:

• the war in Iraq has continued to drag on
• oil spiked up to $140 per barrel
• housing prices have tanked, dropping as much as 50% in some markets
• Bear Stearns was bailed out by the government
• Lehman Brothers wasn't bailed out and went bankrupt
• AIG, the largest insurance company in the world, had to be bailed out
• Fannie Mae and Freddie Mac had to be taken over by the government to avoid bankruptcy
• unemployment reached double digits for the first time in 30 years

It has truly been a difficult time to be an investor during the past decade.  But a closer look at market performance shows the resiliency of capitalism.  The S&P 500 back in March 2003 was just below 900, closing on 3/20/2003 at 876.  After all of those terrible events in the interim, today the SP is just under 1300 - an increase of around 5% annualized.  And that's on price-only basis, dividends which historically account for about 1/3 of market returns are not included in the index levels.

And that's also on an undiversified US large cap only basis; over the past eight years globally diversified index fund portfolios have returned in the 7-12% range (annualized including dividends) depending on the mix of stocks and bonds being considered.

Capitalism does work, and to participate in the gains inherent in capitalism one need not pick the best stocks, or hottest funds, or anticipate interest rate changes, or time the market to get out when it goes down and in before it goes back up, or pay attention to any of the myriad 'new normal' or 'this time it's different' media fallacies.

All we need to to is be invested and be patient.

All the Serious Money is Indexed

A recent New York Times article discussed how index funds are not only the most efficient way for people of modest means to accumulate wealth but are also the best way for wealthy investors to keep and grow their wealth.

The reporter interviewed Princeton professor of economics Burton Malkiel, author of the 1973 investment classic "A Random Walk Down Wall Street" and pioneer in research which shed light on the folly of trying to beat the market. In the article he postulated that of all of the mutual funds in existence or created since the 1970s, the number that actually beat the broad indexes through 2009 would be in the single digits.

The counterpoints in the article from some active managers border on laughable. One compared stocks to baseball batters, saying "If you find the ones with the higher average, you're adding real value." Well no kidding...except that study after study shows that the odds of doing that are about the same as the odds of any single person reading this becoming an American Idol winner.

The same manager also said "We're selecting high-quality companies with earnings streams and eliminating all the bad stocks in the S&P that you have to own because it's an index." Apparently they're buying those great stocks from other active managers who prefer low-quality companies without earnings streams. (Remember they're not buying them from those silly indexers, because the indexers own a proportionate share of everything in the market.)

Malkiel also dispels the notion that commodities belong in a portfolio as a distinct asset class, because by properly diversifying one already has such exposure: "...if you're really well diversified and into emerging markets you're going to have some investments in Brazil, which is natural resource rich. It's simple."

Malkiel also divulges his personal holdings, which include buying some individual stocks "because it's fun. All the serious money is indexed."