Strange Bedfellows

If market timing is the single most heinous investment strategy to strategic, buy and hold investors, then technical market analysis must run a close second.  Technical analysts study the market by looking at charts of market price under the assumption that the price already reflects all of the market’s information about a company or a market.  The study of charts leads to an often baffling kind of analysis where serious investors are reduced to looking at pictures of price movements and then trying to discern what they mean.  There are candlestick charts, point and figure charts, high-low close charts, and there are moving average charts and stochastics charts and moving average convergence divergence (know as MACD) charts.  Technical analysts not only study these pictures trying to find price momentum and oversold and overbought market conditions, they often draw on them placing trend lines and support and resistance lines in a way that might amuse a preschool class given the proper tools of crayons and rulers.  For the record, I am a strong believer in technical analysis because I believe that endogenous uncertainty, or the idea that investors themselves can be responsible for market misbehavior, is an important part of the process of finding good investment values.

It is somewhat ironic, however, that the only other group of investors that I’m aware of that believes that the price has such an important role in the investment process is strategic, buy and hold investors themselves.  They believe that the price of a stock or the market is perfectly rational being determined by large groups of investors with perfect structural knowledge of the economy and perfect economic foresight in terms of how exogenous risk (the news) impacts markets.  Therefore, strategic, buy and hold investors believe that the price always reflects fair value, a position that elevates price to a level of importance that is only equaled by…..technical analysts.

For all of the finger pointing and ridicule strategic investors hurl at technical investors, where they insist that technical analysis is pure quackery, the strategic buy and hold crowd should realize that they are closely related in their approach to how prices are set in the markets.  All of which makes them strange bedfellows, indeed

Buy and Hold as a Tactic, not a Strategy

The latest confusion about the strategy of Buy and Hold investing seems to be coming from commentators that approve of buying and holding as an investment tactic.  They argue (for the most part) that buying “good stocks” and then holding them for a long time is a time-honored investment strategy approved by the likes of Warren Buffet, and therefore they argue that Buy and Hold should be allowed to live.  The two pieces I’ve seen were written by a sell-side analyst at a brokerage firm and a staff writer for a well known online investment advisory website, both of which are monuments to active management in their own way.  How could writers and analysts who work for firms that give ongoing investment advice about buying and selling securities write pieces in favor of buying and holding?

The answer lies in confusing buy and hold investing as an investment tactic with buy and hold investing as an investment strategy.  As a tactic, there is nothing wrong with buying good stocks and holding them for a long time.  But I can assure you, Warren Buffet would never suggest that you should buy them based on their average returns over the past 50 years and then never sell them on the presumption that there is no such thing as an overvalued stock due to efficient markets.  Buffett would conduct exhaustive research in order to conclude that a stock is “good” (offers good value) and he would most assuredly sell it if he thought it was overvalued.  In short, buying and holding is an excellent investment tactic, but it shouldn’t be confused with the Buy and Hold investment strategy.

Buy and Hold as an investment strategy remains a high-risk proposition that supposes that markets are never too expensive to own.  The only time an investor should implement strategic asset allocation (i.e., Buy and Hold) is when markets are unequivocally cheap, which happens maybe 1/3 or less of the time.  Other than that, a more active investment approach is called for.  So the next time you read an article from an analyst at a brokerage firm, or a writer for an investment website, suggesting that they like to Buy and Hold, know that they really mean they like the tactic of buying and holding…..not the strategy.  If they really believed in the strategy they would both be out of business.

Errors, Apologies, and Thoughts on Publishing Perfection

“Please do not 1) send me your papers or other “interesting material” to read, 2) ask finance questions (not my specialty), 3) make me to rewrite sections of my books (I write books, not emails), 4) ask for a list of “other interesting books to read,” 5) ask me to provide career or educational advice, 6) send me passages from Tolstoy or the Ecclesiast on luck and randomness, 7) send me the list of typos in my drafts. Note that I almost always reply (but ONLY to short messages), time permitting (but once) – even to nasty emails. Finally, note that, thanks to my new keyboard, I sometimes reply in Arabic, particularly to academics.” – From Nassim Taleb’s home page

If you don’t recognize the name, hopefully you will recognize the work of Nassim Taleb, the author of the books Fooled By Randomness and The Black Swan.  I suppose when you are demonstratably smarter than everyone else around, you can be very picky about your correspondence.  Today I’m most interested in #7 above where he instructs us “not to send him a list of typos in my drafts.”

My own process for finding all of the typos in my book included having a professional editor, test readers, a professional line editor, and personally reading the manuscript about 1,000 times.  The book itself is 110,000 words and includes 80 Figures and Tables, and reasonable people in the publishing profession have patiently explained to me that every book is published with some amount of errors.  I, however, was aiming to eliminate any and all errors in the text, preferring of course to deal with readers who took issue with my thesis, as opposed to those who found errors in the text.

As of last week the tally is 2 errors in Figures and Tables, and 5 errors in the text.  Readers will note the random plus and minus signs in Figure 2-1 have little to do with the up and down arrows mentioned in the text, and the tiny numbers in the middle of the chart in Figure 9-7 are the numbers for the right side scale of the chart which somehow got misplaced.   Some of the text errors include attributing my associate’s, Michael Kitces, work on withdrawal rates to a piece he wrote in 1998, a somewhat amazing feat since I’m pretty sure Michael was still in college in 1998 (the correct date is 2008).  I used the word “mute” when obviously the point was “moot.”  And last week a client pointed out that I had astonishingly morphed the name of Nobel Prize-winning economist Robert Lucas to John Lucas in several places in the text, a strange phenomenon that combines the name of John Muth, the originator of the Rational Expectations Pricing theory, with the name of Robert Lucas, the brilliant professor who ultimately won the Nobel Prize for expanding his work.  I would have hoped to get the name of a Nobel Prize winner correct.

To Professor Lucas, and Michael Kitces, and to my readers, I apologize for these errors.  Unlike Nassim Taleb, I do welcome your comments about the book in just about any form, length, or point of view.  And somewhat masochistically, I welcome you pointing out any text errors you find.  They will go on the list of things to correct if we publish another version of the book.

In Celebration of Market Timing

I am a market timer.  I reduce portfolio risk and earn excess returns by selling securities that are overvalued and buying securities with the proceeds that are undervalued.  Once I couple the purchase of a security with the sale of the security, I am no longer a buy and hold investor, and I must cheerfully and defiantly define myself as a market timer.  In making this statement, I am joining the ranks of the most reviled investors on the planet, all of whom are considered to be uneducated, easily swayed by investment fads and mass media, and most importantly, are doomed to fail in their investment strategy.  The reason for certain failure is that, unlike buy and hold investors, the decision to sell based on the valuation of securities is fraught with risk that timers will improperly assess value and sell too early or too late.  On the other hand, buy and hold investors live in a mythical world of certainty where security valuation doesn’t matter, and so they ignore valuation in their investment process.  This leads to the somewhat ironic state of affairs where proud market timers who are using valuation to minimize portfolio risk are instead considered to be high risk investors, and buy and hold investors who ignore security valuation are considered to be risk averse.

We all realize that the popular perception of market timing is one where portfolios are traded in extremely short investment time frames, and portfolio diversification is considered irrelevant because investors are willing to take the risk of going to an all-cash position when they feel risk positions are unsafe.  I happen to believe that this manifestation of market timing is a high risk strategy, but only because I don’t believe that investors should ever be 100% certain in their forecasts, and therefore being 100% in stocks or cash is a little too much risk for my taste.  Nevertheless, the idea of being out of the market when it is deemed to be a high risk investment due to poor valuation deserves at least polite applause, regardless of the tactics that are employed.

To be a “market timer” is to join a group of investors that should be celebrating their determination to properly manage portfolio risk.  I believe that searching for good values, coupled with portfolio diversification, are the two unbreakable rules of investing and the two tactics that can’t be ignored by investors in properly managing risk in their portfolios.  So let’s hear it for the market timers out there.  (If I were a musician I would make up a fight song for them.)

“Let’s Suppose” and the “Equals” Sign

It turns out that two of the most destructive forces for the economy are the words “let’s suppose” and the use of the = sign.  When we put the two together they form a combustible combination that gives seemingly well intentioned and rational investors the power to disintegrate assets “at will.”  This is because investors have a desperate need for quantitative models that will justify and “prove” their investment thesis, if for no other reason than it provides much better job security than having an investment thesis based on their good judgment and common sense.  Unfortunately, this state of affairs gives rise to some of the most egregious misuses of the scientific method that one could imagine.

For example, let’s suppose that 8 pumpkin pies = ½ of a new Cadillac CTS.  Therefore, 16 pumpkin pies = 1 Cadillac CTS.  Why not?  As I sit in my office, I suppose that 1 lamp = 1 roll of tape, and therefore if I buy 5 rolls of tape the equation is 5 rolls of tape = 1 current lamp + 4 more lamps.  When we “suppose” in order to use an = sign we turn outrageous and silly statements into a scientific formula that sounds persuasive.  Let’s try some other assumptions on for size with an = sign to follow.  Let’s suppose that investors have perfect structural knowledge, meaning that they know why prices change today and in the future.  Let’s also suppose that they have perfect economic foresight, meaning that they perfectly know how current news will impact future prices.  Then our equation becomes today’s prices + news = future prices.  It may sound impressive, but we might as well be talking about pumpkins and Cadillacs.  Assumptions like these must carry a high burden of proof that they are correct.

How about these assumptions?  U.S. residential real estate prices never go down in value.  Markets always function normally so standard deviation properly measures risk.  Investor behavior doesn’t impact markets so price changes can be measured by the same method used to measure the movement of grains of pollen in water (Brownian Motion).  Or, the market is always in equilibrium except for the news, investors have the same risk tolerance, the same access to information, the same indifference to taxes, investors can borrow at the risk-free rate….and on and on.  These are the basic assumptions used to justify the rational expectations pricing model, which is known to most investors as the efficient markets hypothesis.  It is a powerful and troubling example of what happens when the words “let’s suppose” get followed by an = sign.  It is usually a recipe for financial mischief of all kinds.  Our world is full of quantitative models used to justify investment decisions.  Investors must beware of the assumptions in these models.

Markowitz’s Lost Message

Harry Markowitz is considered the father of modern finance by many, and his paper, Portfolio Selection, published in 1952, is the foundation of the Nobel Prize winning body of work known as Modern Portfolio Theory. It provides the mathematical foundation for strategic asset allocation, which is how professionals apply buy and hold investing to multiple asset class portfolios. To the surprise of many, here is what Markowitz has to say in the beginning of his famous paper:

“The process of selecting a portfolio may be divided into two stages. The first stage starts with observations and experience and ends with beliefs about the future performances of available securities. The second stage starts with the relevant beliefs about future performance and ends with the choice of a portfolio. This paper is concerned with the second stage.”

It is shocking how Markowitz’s work has been misapplied by the investment industry over the years. Instead of using observation and experience to make assumptions about the future performance of available securities, investors are taught to use average past performance of available securities and assume that performance is a certainty. In fact, it is the misplaced “belief” that past performance will repeat itself in the future that makes me believe that buy and hold investing is more like religion than an investment strategy. Investors who misapply Markowitz’s models in this manner must have faith that the past really is prologue to the future. Investors must choose. They can either rely on average past performance for their beliefs about future asset class performance, or they can reach their beliefs based on thorough study of absolute and relative value, market cycles, and technical analysis.

We choose the second method.