Investing Is Playing the Game of Risk
The best portfolios manage risk, not returns.
To be sure, there is no exact definition of what "calling" a market top or bottom involves. In the case of the March 2009 bear market bottom, for example, does "calling" it mean the adviser's portfolio needs to have moved from being all cash to 100% invested in stocks on the exact day of the bottom? If my analysis had relied on a definition as demanding as this, then it wouldn't be surprising that no timers called recent market turning points. But my analysis actually relied on a far more relaxed definition: Instead of moving 100% from cash to stocks in the case of a bottom, or 100% the other way in the case of a top, I allowed exposure changes of just 10 percentage points to qualify. Furthermore, rather than requiring the change in exposure to occur on the exact day of the market's top or bottom, I looked at a month-long trading window that began before the market's juncture and extending a couple of weeks thereafter. Even with these relaxed criteria, however, none of the market timers that the Hulbert Financial Digest has tracked over the last decade were able to call the market tops and bottoms since March 2000. These results add up to perhaps the most important investment lesson of all that can be drawn from this week's market anniversaries: Predicting turns in the market is incredibly difficult to do consistently well. That means that, if your investment strategy going forward is dependent on your anticipating major market turning points, your chances of success are extremely low.
-- Mark Hulbert, MarketWatch (3/10/10)
The above excerpt was penned by the esteemed Mark Hulbert in an article titled "Fools R Us." Appropriately, that article ran in a MarketWatch column on the 10-year anniversary of the NASDAQ Composite's peak of March 10, 2000. Ten years ago the COMP was changing hands around 5050. At last Wednesday's anniversary date it closed at 2358.95, for a 10-year loss of some 53%. Meanwhile, since that peak, the S&P 500's earnings are up approximately 48%, real GDP is better by more than 20%, and interest rates are substantially below where they were back then. If you're a college professor, such statistics don't "foot" with your teachings because professors tend to believe stock returns are all about earnings and interest rates. I concur, but would add the caveat, "That is if you live long enough." As money manager Greg Evans, eponymous captain of Millstone Evans in Boulder, Colorado, writes us:
Hey Jeff, I enjoyed your missive on Mr. Market last week. I use that Warren Buffet allegory quite a bit with clients. One interesting statistic on Berkshire is that its stock price was $38 in 1968 and eight years later, after trading higher and lower, ended up (again) at $38. Most clients would look at that [performance] and say -- it hasn't done anything for eight years so I am going to sell. But an astute investor, looking at the underlying growth in book value, would see an average annual growth rate of 14.6% over those eight years and conclude they should buy more. As to your point that over the long-term stock prices are ultimately determined by their book value, earnings, and cash flows, I have often run numbers on stocks over a 25-year time frame to show to clients. For example, Coca-Cola's (KO) stock price in 1983 was $5.10 (midpoint); and Coke earned $0.30 per share that year. The stock price today is $54, and they earned $3.05 last year. That's a 10.8% annualized growth rate on the stock price; and, a 10.6% growth rate on earnings -- QED.
Surprisingly, however, if an investor bought Coke shares at their peak price in 1972, over the next 12 years the company compounded earnings at nearly double-digit rates (with only four down quarters), yet said shareholder actually lost money! The reason was Mr. Market was unwilling to capitalize that improvement in earnings anywhere near the P/E multiple of 1972. Regrettably, Mr. Market is indeed a manic depressive, which is why the stock market is truly fear, hope, and greed only loosely connected to the business cycle. (See also, Mr. Market: Your Moody Business Partner). And that, ladies and gentlemen, is why the successful investor needs to learn how to manage risk. As Benjamin Graham wrote, "The essence of investment management is the management of risks, not the management of returns. Well-managed portfolios start with this precept."
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