An example about the risks associated with individual stocks !

Allan Roth has written a wonderful book titled ‘How a Second Grader Beats Wall Street.’ Owning the market via indexing does the trick.

In the enclosed article dated June 16^th 2010, “BP Teaches Three Key Investment Lessons,” Allan Roth highlights the risks associated with owning individual stocks! 

He uses the example of British Petroleum (BP) one of the strongest companies on planet Earth...till the Gulf of Mexico disaster (in early 2010) that afflicted one of its offshore platforms causing major oil spill.

Some excerpts,

Let me first state the obvious by saying that owning any one stock is far more risky than owning the stock market as a whole.

BP started the year as one of the most valuable companies on the planet as measured by market capitalization.

Yet it was only one company.

Markets have stayed pretty flat so far this year, but a 50 percent decline in BP stock would equate to a 5 percent decline if your portfolio had ten stocks.

Picking individual stocks increases risk without increasing expected return.

Further says Allan Roth,

Don’t confuse the unlikely with the impossible. 

The collapse of such titans as Enron, Lehman Brothers, and General Motors, could never happen to BP, right? 

BP, after all, has billions of barrels of proven oil reserves which is money in the bank. 

My observations:

·        Investors & stock pickers tend to believe in the invincibility, immortality and invincibility of their favourite companies...something like ‘this (i.e. misfortune) cannot happen to me!’

·        Hence, Roth’s wise words don’t confuse the unlikely with the impossible. 

·        Stock prices in the future are moved by future events, news and information. News is inherently random and therefore unpredictable. What is publicly known (about a company) is more or less built into the market price...what is unknown is the knowledge that will move a stock (in the future) and this is impossible to forecast.

·        Academic studies tell us that essentially all stocks have the same expected return as the market...the problem with individual stocks is they have this greater range of outcome which the academics call Standard Deviation.

·        So, it makes little sense at all to buy an individual stock with this huge range of outcomes when you can have the same expected return at a narrower range of outcomes...via a broadly diversified index!

Link,

http://moneywatch.bnet.com/investing/blog/irrational-investor/bp-teaches-three-key-investment-lessons/1606/?tag=col1;blog-river

" New Index Returns Astound Wall Street "

Enclosed is link to a terrific write up by Dan Solin....it shatters the myths of ....

* 'expertise' in active investing like picking future winners looking at past performance,

* 5-star fund ratings (obviously done in hindsight) and

* some of the 'brightest minds doing sophisticated investment analysis'.

It is time to switch to the simplicity of passive index investing i.e. broad market cap weighted index funds that capture market rate of returns-whatever that maybe.

For me the 'market rate of return' over the long-term is a reflection of the benevolence that is offered by capitalism, enterprise and the free market system.

http://www.huffingtonpost.com/dan-solin/new-index-returns-astound_b_792002.html

" Giving your SIP Investments the value edge "....link to DNA Money article

http://www.dnaindia.com/money/report_giving-your-sip-investments-the-value-edge-vip_1514781

" The Arithmetic of the Financial System "

John Bogle is the founder and former CEO of Vanguard...he is perhaps the strongest proponent of indexing & he launched the first index mutual fund way back in 1976. His creation Vanguard is currently the world’s largest mutual fund company.

John Bogle’s book Enough begins with a wonderful epigram-a short witty poem depicting the reality of the modern financial system. It goes on to read something like this,

Some men wrest a living from nature and with their hands; this is called work.

Some men wrest a living from those who wrest a living from nature and with their hands; this is called trade.

Some men wrest a living from those who wrest a living from those who wrest a living from nature and with their hands; this is called finance.

The epigram is used by the author to describe the correlation between financial system and the economy of a country!

He then goes on to describe the ironclad equation under which the system works, what he terms as The Relentless Rules of Humble Arithmetic.

They are and I am quoting them from his book,

The gross return generated in the financial markets, minus the costs of the financial system, equals the net return actually delivered to investors.

Thus, as long as our financial system delivers to our investors in the aggregate whatever returns our stock and bond markets are generous enough to deliver, but only after the costs of financial intermediation are deducted (i.e., forever), the ability of our citizens to accumulate savings for retirement will continue to be seriously undermined by the enormous costs of the system itself.

The more the financial system takes, the less the investor makes.

The investor feeds at the bottom of what is today the tremendously costly food chain of investing.

John Bogle sums up the above reality in these words, On balance, the financial system subtracts value from our society.

The author laments that we live in a world where we are merely trading pieces of paper, swapping stocks and bonds back and forth with one another...!

The author correctly asserts that all such activities obviously increase the costs and has led to the creation of complex financial derivatives which add to the mayhem due to immeasurable risks.

If I were an investor (or an investment advisor) the following is what I would interpret from the wisdom contained in Enough,

·        The financial system is an additional layer to the real economy that produces goods and services which all of us consume. When I say this, I would exclude plain vanilla commercial banking which facilitates economic activities.

·        As investors, we primarily plough our savings into companies that comprise the real economy...i.e. either as stakeholders in ownership (equities) or as lenders of capital (debt)....and we do this in order to meet our financial goals and objectives. Period!

·        It implies, therefore, as an investor I should try and be closest to the returns generated by the system itself i.e. the market rate of return delivered to investors in the aggregate or as a group. The portfolio that mimics the market average return is obviously a broad market cap-weighted index (fund / ETF)

·        As elsewhere (and also in India) the ‘market rate of return’ includes the performance of various professionals such as MF managers, PMS Managers, Insurance managers, stock pickers, FIIs, hedge funds and so on and so forth.

·        To expand upon the ‘relentless rules of humble arithmetic’...some of these active investors (at random) will outperform the market average in some time periods-such that their (equally brilliant and motivated) counterparts will underperform (at random) by an equivalent amount. Both i.e. the alpha and anti-alpha are usually known in hindsight. The market is not a fairy tale mythical land where everyone can extract excess returns 'above the average' at the expense of other active investors (also trying to outperform.)

·        To conclude: As investors it makes logical sense to reap the benefits of capitalism and enterprise by buying ‘capitalism in the aggregate’ via the market (broad index) portfolio...rather than indulge in (active) guesswork about individual pieces (stocks, companies, sectors and managers)....the individual pieces will exhibit random outcomes-both desirable and undesirable! The individual pieces will have additional (concentrated) risks over and above the market risk.

" Rich and Poor Serve Their Wall Street Masters"

Enclosed is link to an excellent article by Dan Solin, an actual example of portfolio churn which destroyed value for an investor. The author does comparison with passive index portfolios that would have created much more wealth for the investor.

http://www.huffingtonpost.com/dan-solin/rich-and-poor-serve-their_b_812718.html

Criticism of 'Market Efficiency'...but does it allow you to make money hand over fist?

Art Carden is a professor of economics at Rhodes College and the following paragraph is from his write-up, Why Economics is Crucial for Ethics.

“If you are making money hand over fist exploiting inefficiencies in the market, then I will believe you and listen to your criticisms of efficient markets.  Until then, I've seen nothing to suggest that markets are systematically inefficient in a knowable, predictable way.”

Active investors generally believe that ‘pricing inefficiencies or anomalies’ can be predictably & consistently exploited in stock markets....especially in the so-called more ‘inefficient’ emerging markets (such as India).

I believe, that no market can be perfectly efficient i.e.at all times and for all people...this implies that even if inefficiencies exist in the market, they are randomly scattered such that no individual can ‘outperform’ the market averages (by profiting from those anomalies) except for random chance!

To my mind, the practical implication of Art Carden’s observation is:

In a market (e.g. Indian stock market) that has the presence of thousands and thousands of professional active investors (MFs, FIIs, PMS Managers, analysts, stock pickers, treasuries, insurance companies, advisors, family offices, and institutional investors etc)-it is rather difficult for me to believe that individual professionals can keep outperforming by consistently exploiting the mistakes of their equally brilliant and motivated counterparts.

In other words, for an individual (s) to consistently exploit inefficiencies, profit from them and thus beat the market...their counterparts (also highly motivated investors trying to generate alpha) have to consistently turn CHARITABLE and allow others to ‘consciously’ win.

However, even if we believe markets are not efficient, then, in Jack Bogle’s words, (from his interview dated 4^th January 2011, Money Magazine...Investor’s Guide-2011)

You don't need the efficient-market theory to justify indexing. Indexing wins whether markets are efficient or inefficient. In an inefficient market, a good manager may be able to win by five percentage points a year over a decade.

But by definition, a bad manager must lose by the same amount. It all has to average out. So even if the market is very inefficient, the index will still capture your share of the market return.

Link to the interview,

http://money.cnn.com/2010/12/31/pf/investing/jack_bogle.moneymag/index.htm

" Telling someone you can't beat the market, is like telling a 6-year old, Santa Claus doesn't exist."

Professor Burton Malkiel of Princeton University is the author of a very famous investment book, A Random Walk Down Wall Street. The first edition appeared in the early 1970s and it has been so popular that it is now into its 10^th edition.

Burton Malkiel is a strong proponent of low-cost indexing and in the enclosed article and interview on Yahoo Finance-he says that investments via passive indexing (including ETFs) are becoming very popular!

Markets may not be 100% efficient-but it doesn’t mean that one can (consistently) beat them or be above average.

Stock prices (into the future) move at random-because news / fresh information (which causes prices to move) hits the market at random. It essentially implies that there are no ‘past patterns’ that can predict the future.

What is not news is already discounted into the prices by the market. This happens because the market is comprised of thousands of competitive, motivated and profit seeking people who do analysis 24*7*365. In other words prices (in the market) already reflect what can be known!

Hence, all that investors need to do is invest into low cost index funds / ETFs for their long-term financial goals and objectives.

And yet active management is hugely popular, people keep trying to beat the market and pay others to do the same ...why? In the words of Burton Malkiel,

“Telling someone that you can’t beat the market, is like telling a six-year old that Santa Claus doesn’t exist,” according to Malkiel. Basically, people deny the facts that show most investors don't make huge profits. 

He explains that we all keep trying for two fundamental reasons: investing is fun and some people DO make money.

In the market peoples' beliefs are similar to the fable of Lake Woebegon-the fictional land-where all children are ‘above average!’ Unfortunately, in their attempt to chase the rainbow of 'beating the market' many fail to capture the market average return, which over the long term is decent enough to meet many of our financial goals.

According to me, the sage advice of Dr Burton Malkiel is applicable to investors everywhere!

Link to the Yahoo Finance article and interview,

http://finance.yahoo.com/tech-ticker/burton-malkiel-markets-aren’t-100-efficient-but-you-still-can’t-beat-‘em-yftt_535789.html