Overstaying bad investments

This is the first article in the Investing series. It is introductory and provides a range of observations. Sophisticated investors may want to skip it as it is basic and aimed at novice investors. It does, however, contain some elements that will recur in subsequent articles.

Market Efficiency

The late James Lorie, from the University of Chicago, was one of the early investigators of what is known as the Efficient Market Hypothesis (EMH). Early research begun in the 1960s concluded that stock markets were efficient in the sense that one could not design trading rules (technical analysis) that would consistently outperform markets. It was also determined that fundamental analysis (the Graham-Dodd value approach) was no better.
Mr. Lorie, in his inimitable fashion, described the market in light of these conclusions as “a game worth winning, but not worth playing.”
Much controversy has arisen regarding the validity of the EMH. Some of this criticism is misguided in that it attributes claims never made by proponents. For our purposes, I would like to differentiate between short and long-run, without precisely defining these periods. In the long-run, markets can clearly become over or undervalued. However, even those who make such claims usually do so after the fact rather than during the bubble or distortion. As examples: In 1999 who predicted an imminent dot com collapse or in 2005 predicted the housing collapse? Some did, but they were dismissed as “wingnuts.”
I believe that EMH holds in the short-term but less so in the long-term. Thus, whether markets in general are priced correctly or over or undervalued, individual stocks within markets are “correct” in the sense that it is difficult to find stocks that are over or undervalued. That is, stock picking cannot produce excess returns on any sustained basis.
More will be said about short-run and long-run differences later in this series.

We are Average

Most of us have the “Lake Wobegon” disease and believe we are above average and can generate superior returns. With respect to investing, I would almost guarantee that is not true for anyone reading this post (including the writer). We are all “average” investors and we should never forget that. Hubris is often responsible for our biggest blunders.
The fact that we are “average” should not be discouraging. It is consistent with the findings of the Efficient Market Hypothesis. It does not mean that we cannot make money investing, merely that we cannot obtain superior (outperform the benchmarks) returns on a consistent basis. Don’t feel bad, highly paid “experts” running mutual funds overwhelmingly fail to equal their market benchmarks.
Recognition that we are “average” is important to investing success. It should prevent us from getting overextended in positions and overstaying bad investments.

Average Investors Can Earn Market Returns

In the section above you were insulted by being referred to as average. Because you are average, it means you can achieve market returns. Actually, even below-average investors can achieve this result. All you have to do is diversify your portfolio to approximate the market and you will approximate market returns.
That is easy to do, even for small investors. Simply buy an index fund that mirrors the average you want to match. There are mutual funds that reproduce the performance of the Dow, S&P 500, Wilshire, Nasdaq, etc. You can buy one of these and forget everything else. You will virtually equal the market as you have defined it. Exchange-traded funds (ETFs) are also available that provide the same benefit.
Fully diversified portfolios will approximate market returns. Index funds and some ETFs provide that diversification for you.

What Happens If You Expect the Market to Underperform?

If you expect that the stock market is going to go down say 20%, why would you feel comfortable investing with an expected return of negative 20%? It is little consolation to be able to say that you did as well as the market if the market loses money. Of course neither you nor anyone else would be happy unless you were required by law or charter (as some mutual funds are) to remain in the market.
Investors with such expectations would likely reduce their positions in stocks. The strength of your expectations and the costs of being wrong are two factors that influence your portfolio allocations.

How Average Investors Might “Beat the Market” or “Underperform the Market”

In periods when you expect market returns to be unsatisfactory, you might reasonably decide to detach your performance from the stock market. The simplest strategy is to get out completely. That is usually not a wise strategy because there is no guarantee that your expectation of the future will be fulfilled.
Two other ways are to reduce your exposure to stocks and/or shift your weightings.
Reducing your exposure to stocks involves taking money out of play. You might move some funds out of equities into bonds, thus reducing your exposure to equities. On the other hand, you might leave all your funds in equities but shift the allocations. Of course both strategies can be used – reduce exposure and shift weightings.
One of the simplest ways to change weightings is via the use of sector funds. Sector funds specialize in various sectors of the economy. If you believe retailers or manufacturing might outperform the general market, you might want to overweight these sectors. Doing so, puts you in position to either over or underperform the general market, depending upon what develops.
For investors who prefer to approximate the market, an index fund or an ETF is efficient. Taking some money out of this index fund and placing it into one or two sectors is an effective way to retain some diversification while weighting a bit more heavily toward those sectors you perceive as having value.

Wave Effects

Stocks tend to move together. Studies show that about 50% of an individual stock’s performance can be attributed to the general market. The other 50% is unique to the company. Market statisticians refer to this correlation as “beta.” Other than mentioning the concept, there is no reason for delving further into the intricacies of how beta is calculated. In my opinion, it is virtually a useless concept.
If you believe the general stock market will not do well, your favorite stock or sector will be heavily influenced. If your expectations are particularly negative, you might want to deploy your assets to alternative investments.
Even so-called low beta investments are not immune to market waves as witnessed by the sell-off of precious metals when the markets turned down in 2008.

Expectations

Investing first and foremost depends upon expectations. Current prices are determined by expected future performance, not by past performance. Unsophisticated investors frequently reveal themselves when a company’s earnings report comes out and they say: “Earnings went up but my stock went down?”
The past is useful information only to the extent that it enables you to make better judgments regarding the future. It has no relevance to current prices.
To be a superior investor, you must be able to anticipate the future both earlier and more accurately than others. James Lorie recognized this exception to the efficiency of markets. Despite all of the mathematical testing, he asserted that some people were capable of beating markets. Their methods were suspected to be the ability to see the future better than the rest of us. Evidence for this, according to Mr. Lorie, is the people on their yachts at St. Tropez who do not reveal talk about their methods.

Your Expectations may be Correct but Your Investments can be Wrong

Having accurate expectations of the future is the only way to obtain superior returns, but it is no guarantee. Often you are right in your prognostications but too early.
Being correct and too early generally results in double disappointment. The first is when you take your initial position and underperform because you are ahead of market expectations. The second arrives after you have given up the position, believing your analysis to be incorrect. Then the market finally catches up to your “wisdom” and the investment moves up. By this time, you are out of your position.
Thus, what you are really trying to do is to forecast what market expectations will be in advance of their changing. You can be right regarding reality and still lose money if you are too early. John Maynard Keynes colorfully expressed this anomaly thusly: “The market can remain irrational longer than you can remain solvent.”
I have personal trading records vividly demonstrating the “too early” problem. For quite a while I was convinced that the banks and especially Fannie and Freddie would collapse. I shorted (via the use of puts) these entities. I entered and exited these trades many times without making any money (actually losing money). Finally, out of frustration, I threw in the towel only to see my expectations fulfilled but not my net worth. I was correct but too early.

Investing is Not Easy

Given the above discussion regarding expectations, it is easy to see why markets seem so confusing. The early basis for the Efficient Market Hypothesis likened stock prices to a random walk process.  There is no easy way to “make a killing in the market,” at least legally. But this is the reality that we must deal with. In the words of Frank Knight, a great economist from the University of Chicago, long retired before the EMH studies:

We have to adapt and overcome, that’s all we can do.

His advice was not directed at the stock market but at life in general. It is advice we all should heed as this economy continues to deteriorate.

Where Do We Go Next?

The next article in this series will lay out a set of expectations regarding the future.
Subsequent articles will deal with personal objectives. Three different set of objectives will be established for generic investors. The first will deal with a retiree or near-retiree. The second will deal with a middle-aged worker and the final one with someone just beginning their working career.
For each of the three generic investors, expectations of the future and personal objectives will be used to develop an investing strategy. Markets beyond the stock and bond markets will be included in the discussions.