Monday, August 10, 2009
Motivating today's post is a speech by James Montier about efficient market hypothesis that John Mauldin posted on Barry Ritholtz' site and to a lesser extent some comments left by a reader on Sunday's post. The Montier piece is worth reading but roll up your sleeves and have good cup of mud before you get started it will take a while.
You probably know the joke about the two economists walking down the street and find a $10 bill on the ground and the one economist says the $10 isn't really there, someone would have picked it up by now. The idea being that the market correctly prices in all known information. The thing is, occasionally there is a $10 bill on the ground and someone has to be the first one to find it.
One idea I've tried to convey here is that no approach or method of investing can always be the single best way. Every so often a generally successful strategy will appear to not work very well for a while. With efficient market hypothesis (EMH) this can mean that the collective consciousness that takes stocks up to some highwater mark can turn out to have been incorrect due to things like incorrect expectations, an external shock or something else. Also EMH relies on known information so the market can quickly come to know something new that is important enough to cause a dramatic repricing.
I've never been one to rely on EMH. In past posts I probably said something like the market tends to price in what it knows but occasionally gets things wrong.
The Montier piece gets into all sorts of different pricing models, how people try to apply logic and reason to markets and so on. I've never been a big fan of these because I believe it tends to bog down the process to the point of making it much more complicated than it needs to be, makes it easy to lose the forest for the trees with no guarantee of a better result. It seems to me that people who do bog down in this stuff tend to miss the big macro events.
Too much attention to rules at the expense of the big picture can lead to less diversification and poorer results (risk adjusted or otherwise). The fact is that very expensive stocks can do fantastically well as can inexpensive value stocks. Often the economic or cyclical backdrop plays a role as to whether now is the time for very expensive or very inexpensive to do better. It would follow that exposure to both would mean you would always have exposure to what was doing better.
Another example that draws some strong opinion, at times it makes sense to sell strength and at other times sell weakness. In May, 2007 Citigroup (C) was trading in the $50s. Coinciding with the peak in October, 2007 Citi went into free fall dropping from $47 down to $30 on November 26. Anyone selling on that day at $30 would have seen it go back up to $35 by December 11 but given what happened could we really say a sale on weakness at $30 was bad?
In May 2008 I put up a post about selling some of our position in Statoil (STO) because it had rocketed so far so fast. I sold strength. The sale itself was quite lucky but reducing exposure to something that goes up 48% in two months (as was the case with STO back then) is not the single stupidest thing you will ever do. Back to EMH, how can a stock go up that much in two months?
If nothing can always be the best then it makes sense to consider multiple tactics in the portfolio. This makes the most sense to me.
The reader comment in question says that buy and hold simply works the best but that people should have no more than 50% in equities. I am not a believer in broad proclamations about what other people should do.
He also goes on to say that you cannot expect advisors to outperform the market. I believe the reader has the wrong focus. People need to have enough money for when the time comes. That may or may not mean outperforming the market. If a 50 year old needs $25,000 a year to live on, has $1 million in the bank and is saving $20,000 per year how much do they need to beat the market by? Conversely, another 50 year old who needs $40,000 to live on, with $400,000 saved and putting away $10,000 has more of a need to try to beat the market.
A big thing I focus on is trying to avoid the full brunt of down a lot. When this is done successfully it does a couple of different things. It reduces the chance for succumbing to emotion with panic selling and it also can reduce the consequence of having to pay for an emergency at a bad time in the market cycle. Obviously trying to avoid down a lot is an active approach. This is a value that anyone can add with proper research.
Getting what is right for you boils down to proper asset allocation and a correct assessment of volatility tolerance. Anyone can do this themselves or with the help of some type of planner. Of course this can also be done incorrectly either by a do-it-yourselfer or by some type of planner.
Tonight ESPN will be showing a two hour documentary called The Lost Son of Havana after the Red Sox Tigers game about Luis Tiant's trip home to Cuba a couple of years ago.