What I'm going to say here is simple, yet utterly essential to bond investing. Bond yields are cyclical. These cycles are different from than stock investing cycles, and easier to identify. Technical analysts in particular love to chart stock movements over various period of time, and from those movements, to deduce grand trends. They give them fancy terms, like "Elliott Wave". They'll argue that a sharp upward movement in stock prices is really a head-fake in a larger "secular" bear market. Some will see deeper meaning in the hourly fluctuations of a specific stock; thus unleashing a storm of day trades.
Bond cycles are much simpler. Bond yields go up for a relatively long time, and then they go down. I have a spreadsheet (mentioned before) which begins with bond yields over a very long time (from 1946 to the present). The key yield for my purposes is the Moody's seasoned Baa yield. This is a benchmark bond yield for a "typical" corporate bond of mid-level investment quality and long-term duration. It's not a blue-blood bond, but it's a good way from junk. These bonds have some investment risk, particularly over time, but that risk is quite small. Diversification in the bonds you buy will largely take care of this risk.
In 1946, the first post-war year and the year of my birth, the Moody's seasoned Baa yield was 3.4%. Not great, considering that inflation that year ran at 14%. Still, the BAA yield stayed in that general range for the next ten years. It then moved into the 4% range, then 5% by 1966. By 1968, the rate had jumped to 8.5%, and finally topped out at 16.1% in 1982. Rates then began a long, slow decline: back to 8% by 1996, and 6.5% by 2007. There was then a tsunami between 2008 and early 2009, which almost disappears in the official statistics for those years (7.44% and 7.29%). In fact, in late 2008 and early 2009, corporate yields of all kind skyrocketed! Many issues topped 20%. Since then, however, the long-term cycle has reasserted itself, with the seasoned yield somewhere under 6% right now.
Notice, over nearly 65 years, a grand swoop up, and a grand swoop down. Lots of business in between, but that's the bottom line. So, being astute cycle experts, what's next? Will the grand down-trend continue back to those 3% levels of the 1940's? Damned if I know. While hindsight is 20/20, the future is almost always murky.
Still, there are a couple of really important things you can learn from this long cycle. 3% is a fairly rotten long-term bond yield, and 16.1% is a really high one. So, it's simple, right? Don't buy bonds with a 3% yield, and load up when they're 16%. Yeah, true enough. But when those bonds were yielding 16%, inflation was running over 20%. Guess what? People deserted bonds in droves in 1982! They were terrified of hyperinflation (Zimbabwe style), and feared bonds like the plague. You couldn't give the darn things away. Back in the fifties, lots of folks were pleased as punch to lock in a 3.5% yield: they were being responsible and avoiding risk.
Clearly, those few brave souls who dove in in 1982 were rewarded extravagantly. The long bonds they bought went up and up and up in price. They were geniuses. So, what happened to the idiots who bought in 1950? Well, THAT DEPENDS. If they made a lump sum investment, and did nothing afterwards, they got slaughtered. Even if they held bonds to maturity, inflation devastated their results. If, however, they kept investing, and particularly, if they reinvested their income as it came in, well, amazingly enough, they did very well too! Why? Because a regular investment program let them buy some high yield bonds too. Almost every scenario I have run confirms the same thing; stay in the bond market long enough to catch the full up and down, and you'll prosper.
Of course, in the long run, we're all dead, and few folks have a sixty-five year investment horizon. Can good things come with a shorter time line? Possibly. I'll have more to say about that in awhile.
Monday, November 1, 2010
Thursday, October 28, 2010
So what's wrong with bonds?
My first three blogs have focused on the things I like about bonds: predictability and durability. Believe me, I'm not alone in liking these qualities. The last couple of years has seen a stampede into bonds. People horrified by the losses they experienced in stocks have sought safety in bonds. In the process, though, they have triggered a wave of sell-side advice. Bonds, particularly bond funds, say many folks, have overreached. Prices have risen so drastically that there is no further upside. Since rising bond prices means lower yields (this is a constant of bonds, and you should run through the logic until you GET it), bond buyers are taking on very large risks for very small gains.
What do I think? Well, I pretty much agree. If you do what most folks are doing, which is to buy into bond funds, you are asking for trouble. I'll talk much more about bond funds in a future blog. For the time being, just know that I don't like them, and would strongly advise against them, now or pretty much ever. Any time that buying a bond fund would be a good idea is a time when buying individual bonds is a far better one. Period. Just an opinion, of course.
So, what's the knock on bonds? It relates to yield. Bonds often don't yield much, particularly in comparison to stocks (remember that squishy 9-10% figure the pundits cite?). Short term Treasuries (3, 6 and 12 month maturities) have ZERO yield, three years out is still only 1/2%. Even ten year maturities are a measly 2.65%. Only the thirty year treasury (3.875%) offers a shred of hope of meeting inflation and taxes. That's pretty bleak. You won't lose your principal, but its buying power will decline over time.
Corporate bonds are better, but still pretty chintzy over shorter time spans. A Goldman Sachs bond (A rated) will yield under 4% over four years. Not great, but it makes the government bond look sick. Take it out to 2037, and the GS yield is 7.2%. This yield increment over the treasury is the difference between making REAL money and breaking even. So, why not buy a long bond?
Well, the first risk relates to rising interest rates. As demonstrated in my last blog, an increase in rates will trigger a decline in the bond's market price. That's a problem if you need to sell, and a very good reason not to buy a bond if you have a short investment horizon. The second risk is worse: inflation. Right now, we have very low inflation, perhaps even a whiff of deflation. So, the 7.2% you can get by going long is pretty good. You can pay your taxes and still have a nice, real return. Should inflation flare up, though, that real return will decline by the amount of inflation. AND, the bond's price will fall as rates rise. You'll feel bad, and consider selling.
What to do, what to do? If you know the future, it's easy. That foreknowledge in 1980-82 or 2007-2008 would have led you to raise cash, and wait until rates rose to the stratosphere. Then you would have locked them in. In real life, though, nobody knows what's going to happen next. So, I would suggest a method. If you have money to invest, and a long-term bond rate looks attractive in comparison to present inflation, then buy some bonds to snag that yield. Don't bet the farm. If rates rise, don't panic. Buy some more, locking in that higher yield. Keep buying until rates have clearly peaked, then buy a lot, thus locking in near-peak yields. How do you know when rates have peaked? Well, they'll start going down. You'll miss the top, but will probably get in well before the bottom.
This approach presumes that you have money to invest, and will have more in the future. Part of that future money will, of course, come from the bonds you already own. The rest should, one hopes, come from saving part of your income.
Does this work? I'll talk about some analysis I've done of bond investing over various time periods. I think it's extremely interesting, and might put stock investing to shame.
What do I think? Well, I pretty much agree. If you do what most folks are doing, which is to buy into bond funds, you are asking for trouble. I'll talk much more about bond funds in a future blog. For the time being, just know that I don't like them, and would strongly advise against them, now or pretty much ever. Any time that buying a bond fund would be a good idea is a time when buying individual bonds is a far better one. Period. Just an opinion, of course.
So, what's the knock on bonds? It relates to yield. Bonds often don't yield much, particularly in comparison to stocks (remember that squishy 9-10% figure the pundits cite?). Short term Treasuries (3, 6 and 12 month maturities) have ZERO yield, three years out is still only 1/2%. Even ten year maturities are a measly 2.65%. Only the thirty year treasury (3.875%) offers a shred of hope of meeting inflation and taxes. That's pretty bleak. You won't lose your principal, but its buying power will decline over time.
Corporate bonds are better, but still pretty chintzy over shorter time spans. A Goldman Sachs bond (A rated) will yield under 4% over four years. Not great, but it makes the government bond look sick. Take it out to 2037, and the GS yield is 7.2%. This yield increment over the treasury is the difference between making REAL money and breaking even. So, why not buy a long bond?
Well, the first risk relates to rising interest rates. As demonstrated in my last blog, an increase in rates will trigger a decline in the bond's market price. That's a problem if you need to sell, and a very good reason not to buy a bond if you have a short investment horizon. The second risk is worse: inflation. Right now, we have very low inflation, perhaps even a whiff of deflation. So, the 7.2% you can get by going long is pretty good. You can pay your taxes and still have a nice, real return. Should inflation flare up, though, that real return will decline by the amount of inflation. AND, the bond's price will fall as rates rise. You'll feel bad, and consider selling.
What to do, what to do? If you know the future, it's easy. That foreknowledge in 1980-82 or 2007-2008 would have led you to raise cash, and wait until rates rose to the stratosphere. Then you would have locked them in. In real life, though, nobody knows what's going to happen next. So, I would suggest a method. If you have money to invest, and a long-term bond rate looks attractive in comparison to present inflation, then buy some bonds to snag that yield. Don't bet the farm. If rates rise, don't panic. Buy some more, locking in that higher yield. Keep buying until rates have clearly peaked, then buy a lot, thus locking in near-peak yields. How do you know when rates have peaked? Well, they'll start going down. You'll miss the top, but will probably get in well before the bottom.
This approach presumes that you have money to invest, and will have more in the future. Part of that future money will, of course, come from the bonds you already own. The rest should, one hopes, come from saving part of your income.
Does this work? I'll talk about some analysis I've done of bond investing over various time periods. I think it's extremely interesting, and might put stock investing to shame.
Wednesday, October 27, 2010
Continuing Bond Basics (Bodaciously)
OK, I have follower now. I suspect somebody I love lobbied hard, but what the heck!
My last blog focused on bond basics: their initial pricing, end pricing, and what might happen in the meantime.
Now I want to talk a little about income streams. You can (and should) think of a bond as an income stream. Those bi-yearly payments will flow to you until the bond matures. It's income, and very valuable, particularly as you grow older. You may be surprised to know that traditional stock analysts also work from the perspective of an income stream. They talk about the discounted (or present value) of a company's future income stream (the money the company will generate over time). If you anticipate robust growth in a company's earnings, then you will pay more for the stock right now. If it's going to decline over time, then you'll pay much less for that stock, even though it might be highly profitable right now.
What's the difference between the income streams from stocks vs. bonds? Predictability. Make a basic assumption about the company behind a bond, and you know precisely how much money that bond will generate over its life. What assumption? Well, will it go belly up? In 2009, I asked that simple question about Goldman Sachs and JP Morgan. Would they survive the tidal wave of mortgage failures, or not? Since Uncle Sam had backed them to the hilt, I decided that they would, indeed, survive. After that, everything was simple.
How about anticipating the future income stream of a stock? Oops. Get nineteen factors absolutely right, miss the twentieth, and a future Microsoft suddenly morphs into an also-ran. In 2009, an almost endless string of stocks with unblemished histories of rising dividends suddenly cut those dividends to the bone, or eliminated them entirely. JP Morgan went from $.38 a quarter to a nickel! Retirees trying to live on those dividends experienced an 87% cut in income. And, the price of the stocked plummeted from $47 to $16, a 66% haircut. Even though the stock has recovered robustly (to a recent $38, the dividend still lingers at a nickel. Who know when it'll be back at $.38? Now, what happened to Morgan's bondholders? Nothing, absolutely nothing ... unless they sold in a panic.
A predictable income stream is golden. It's why people go to work, it's why retirees love Social Security, and it's why people getting ready for retirement will often hand huge sums over to insurance companies in return for an annuity. An annuity will promise a given return until the buyer's death. A sixty-five year old might hand over $100,000 in exchange for a guaranteed $500 monthly check (6%) until she dies. Most financial advisors will encourage her to do this.
Here's my question: why on earth is this gal not buying bonds in the same amount? At age 65, she can reasonably expect to live perhaps 25 or 30 years more. So, what if she bought bonds maturing in 2035 with that same 6% yield? She would get her $6000 a year until 2035. At that point, she (or her grateful heirs) gets her money back, all of it. The boob with the annuity? He's either dead, in which case the money's gone, or he's nearly dead, in which case the money will soon be gone. So, what sounds like the better investment to you?
By the way, such bonds exist; I just checked. One example: a Goldman Sachs issue has a maturity of 2036 and coupon of 6.45%. It trades under par (91.2), to yield 7.2%. You all know Goldman Sachs. It's had a wild ride, but has weathered the recession. It's high medium quality (A2 S&P, A- Moody's), and a bank that "too big to fail." Now, I'm NOT saying to go out and buy that specific bond. You would need to do due diligence; analyze the company and make up your own mind about whether it will still be around in 2036. What I am saying is that there are plenty of similar issues out there, and most of them will be fine investments.
My next blog will focus bond critics, and why those guys may be missing the boat.
My last blog focused on bond basics: their initial pricing, end pricing, and what might happen in the meantime.
Now I want to talk a little about income streams. You can (and should) think of a bond as an income stream. Those bi-yearly payments will flow to you until the bond matures. It's income, and very valuable, particularly as you grow older. You may be surprised to know that traditional stock analysts also work from the perspective of an income stream. They talk about the discounted (or present value) of a company's future income stream (the money the company will generate over time). If you anticipate robust growth in a company's earnings, then you will pay more for the stock right now. If it's going to decline over time, then you'll pay much less for that stock, even though it might be highly profitable right now.
What's the difference between the income streams from stocks vs. bonds? Predictability. Make a basic assumption about the company behind a bond, and you know precisely how much money that bond will generate over its life. What assumption? Well, will it go belly up? In 2009, I asked that simple question about Goldman Sachs and JP Morgan. Would they survive the tidal wave of mortgage failures, or not? Since Uncle Sam had backed them to the hilt, I decided that they would, indeed, survive. After that, everything was simple.
How about anticipating the future income stream of a stock? Oops. Get nineteen factors absolutely right, miss the twentieth, and a future Microsoft suddenly morphs into an also-ran. In 2009, an almost endless string of stocks with unblemished histories of rising dividends suddenly cut those dividends to the bone, or eliminated them entirely. JP Morgan went from $.38 a quarter to a nickel! Retirees trying to live on those dividends experienced an 87% cut in income. And, the price of the stocked plummeted from $47 to $16, a 66% haircut. Even though the stock has recovered robustly (to a recent $38, the dividend still lingers at a nickel. Who know when it'll be back at $.38? Now, what happened to Morgan's bondholders? Nothing, absolutely nothing ... unless they sold in a panic.
A predictable income stream is golden. It's why people go to work, it's why retirees love Social Security, and it's why people getting ready for retirement will often hand huge sums over to insurance companies in return for an annuity. An annuity will promise a given return until the buyer's death. A sixty-five year old might hand over $100,000 in exchange for a guaranteed $500 monthly check (6%) until she dies. Most financial advisors will encourage her to do this.
Here's my question: why on earth is this gal not buying bonds in the same amount? At age 65, she can reasonably expect to live perhaps 25 or 30 years more. So, what if she bought bonds maturing in 2035 with that same 6% yield? She would get her $6000 a year until 2035. At that point, she (or her grateful heirs) gets her money back, all of it. The boob with the annuity? He's either dead, in which case the money's gone, or he's nearly dead, in which case the money will soon be gone. So, what sounds like the better investment to you?
By the way, such bonds exist; I just checked. One example: a Goldman Sachs issue has a maturity of 2036 and coupon of 6.45%. It trades under par (91.2), to yield 7.2%. You all know Goldman Sachs. It's had a wild ride, but has weathered the recession. It's high medium quality (A2 S&P, A- Moody's), and a bank that "too big to fail." Now, I'm NOT saying to go out and buy that specific bond. You would need to do due diligence; analyze the company and make up your own mind about whether it will still be around in 2036. What I am saying is that there are plenty of similar issues out there, and most of them will be fine investments.
My next blog will focus bond critics, and why those guys may be missing the boat.
Thursday, October 21, 2010
Why not stocks?
As I see it, an investor two main choices: stocks and bonds. I know, pretty obvious. And, lots of folks will complain that this is way too limited. How about commodities (GOLD!), futures, currency plays, derivitives, real estate, collectibles, etc? Well, to be succinct (and therefore deliberately exaggerating a bit - I'll have more to say about alternative investments in time), they are speculations, not investments. What's the difference? It's huge and fundamental. Both stocks and bond have a yield. Sometimes that yield is pretty small (a tiny dividend, a low interest rate), but it's real.
Stocks are like the American dream, partial ownership of a corporation, its assets, and its earnings both present and future. Even if the corporation has no dividend, its earnings tend (over time, over time) to be reflected in the stock price. If they go up, the price will eventually reflect that.
Bonds are an IOU issued by a corporation, with a stated rate of return and a stated end date. Until that end date, bonds are legally obligated to pay the stated rate on a regular basis (typically twice a year).
Most other "investments" lack this yield feature. They are a zero-sum game: one person wins, another loses. There is no earnings engine behind copper, sugar, puts, or beanie babies. They require a "greater fool"; someone to pay you more than the thing has cost you. Maybe that person exists, maybe not. At all times, you need to consider that the greater fool is you. As they say in poker, if you look around the table and don't know who the sucker is, then it's you.
So, assuming you are interested in investing, why not buy stocks? Great fortunes have been made in them, and stock proponents just love to tout their long-term superiority over bonds. Just think of IBM, Microsoft and Google! Peter Lynch raved about ten-baggers (stocks that went up ten times from purchase to sale), and most stock brokers and investment advisors cite long-term returns for stocks over the past century (or whatever time period is most advantageous to their case) of 9-10%.
The problem is that this rosy figure is largely crap. The farther back you go, the greater the inaccuracy, due to the simple fact that the return is calculated from companies that still exist! All the ghosts (buggy whip makers, Grants, dozens of early computer makers, Enron, Bear Sterns, Lehman Brothers, Chrysler, and GM), and the huge fortunes they destroyed, are conveniently discarded from the computation. Yet real people owned those stocks, and their long-term results were severely degraded in the process. Don't forget, we've just completed an entire decade during which stocks went absolutely nowhere. That's zero return, before inflation (so really, a loss of principal)!
Now don't get me wrong. I actually think there is a case to be made for stocks, at least in theory. Just buy them when they're cheap. Spring of 2009 was a great time to do this. In fact, the best tool for identifying such opportunities is hindsight. To quote Mark Twain (loosely): "Buy a nice little stock, wait till it goes way up, then sell it. If it doesn't go up, then don't buy it." That's a perfect way to describe the art of timing!
My point? Timing is very difficult. Most professionals fail miserably; why do you think you'll do better? I can't overstate this. PROFESSIONALS FAIL MISERABLY at the very thing they claim to do: outperforming a monkey. The monkey throws darts at a newspaper to pick stocks; a professional dredges through reams of statistics and charts to do it. They both achieve, in the aggregate, the same result. Of course, the monkey doesn't charge anything, and so is the better choice for picking a portfolio. I'm serious!
Sure, I know you worship the mega-monkeys: Peter Lynch, Warren Buffett, the Barron's round table sages, etc. But take 100 dart-throwers, and you will, after ten years, come up with one or two simian geniuses who have vastly outperformed the market. Would you bet on these super-chimps being next year's champs? Want a case in point? Bill Gross, legendary stock-picker for 15 years, just quit after five straight years of crappy results. He's highly apologetic, specifying his "mistakes." I disagree. The odds just caught up with another King Kong.
Am I saying the professionals are idiots? Not at all; in fact, the opposite. That's the problem. There are THOUSANDS of brilliant folks out there trying to out-psych each other. Chart-readers are divining mystical data trends; fundamentalists are analyzing cash flows, macro-guys are predicting the rise of China and fall of America, ad infinitum. Each one of them is bright. In the aggregate, though, they tend to cancel one another out. Burton Malkiel and his folks have it right. At any given point, the price of a stock or group of stocks represents pretty much everything that everybody knows. Good news is baked in for high-performers; disaster for laggards. You can make a guess, and be right, but don't assume it's because you were smart. The course of a stock, or a group of stocks, over a short period of time, is a random walk. In time, a stock, or a group of stocks, will move according to underlying value, but that movement is inherently unpredictable, as predictable value is always discounted in a stock's present price.
What to do with stocks? Well, forget timing, forget analysis. (Perhaps even forget stocks.) If you do choose to own them (and diversification is probably the best reason), then buy an index fund or ETF, invest regularly, and close your eyes. In twenty or thirty years, you'll probably be pleased. DON'T time the market, DON'T sell when you're discouraged, and DON'T double down when you're just made a killing. You'll do just as well as all the other patient monkeys, much better than most impatient monkeys, and much better than most professionals (who are, after all, a merely a subset of the second group).
Why does timing fail? It should be possible, right? Occasionally, there come times when things are OBVIOUSLY cheap (again, Spring 2009). They were cheap because people were scared, and so were you. Your brain told you that you couldn't miss, but your gut said things might get a lot cheaper. So, you did nothing. We all act like this, and in reverse when things are obviously expensive.
I do think there is an answer. When it's painful, it's probably the right thing to do. So, do something, but not so much that you can't sleep at night (perhaps with an Ambien, to be sure). You need to buy something when your gut tells you it might go to zero and your brain tells you it's a screaming bargain. You need to sell something when the id screams about losing out, while Mr. Brain is shrieking "nosebleed!". BUT, this simple answer is very difficult! Human nature being ... well, human, few people can time when timing is objectively feasible.
Is there an investment that can work better for real people? We come back to bonds. I like them a lot. There is an admirable simplicity to a bond, despite its reputation as arcane and complex. A bond has a beginning date, an end date, and a predictable income stream (the coupon) in between. A bond has a beginning price and an end price, which are usually the same. A typical bond will be issued at $1000, with a specific coupon rate (say 6.5%) and a maturity date (usually from one to thirty years). In this example, you will receive two payments of $32.50 a year. When the bond matures, you get that $1000 back. That's pretty simple, right? You know exactly how much money you're going to make, how long it will take to make it, and when you're going to get your entire investment back.
Of course, interest rates go up and down. Therefore, a bond must reflect those changes in the meantime. That 6.5% coupon was the going rate at the time of issue (for that maturity and credit quality). If the rate goes up to 7% for new bonds, then older ones will have their price adjusted so that they too yield about 7% to a buyer. So, the quoted price of your 6.5% bond will go down (perhaps to $928). Now its $65 of income is 7% of $928. This might cause you distress, and is the reason most experts are screaming that you shouldn't buy bonds now. You've "lost" $72, or 7.2% on a small upward movement (1/2%) in yield! True enough, but what happens if you do nothing? It's not a loss unless you take the loss. Hold the bond to maturity, and you get that $72 back, for sure. In fact, it really doesn't matter how low it goes, you WILL get the money back! That's huge. As opposed to stocks, there really is a "correct" price for a bond, at least eventually.
Are you interested now?
Update 11/2015. Well, now I can report on stock returns with another five years of perspective. In the commentary above, I mentioned that we had just completed a full decade of zero returns for stocks. Well, using a standard Dow calculator, it now appears that the return for the last FIFTEEN years has been 2.61%! Now fifteen years is a pretty long stretch for such crappy returns. It makes my most plain vanilla scenarios look absolutely world-beating!
Stocks are like the American dream, partial ownership of a corporation, its assets, and its earnings both present and future. Even if the corporation has no dividend, its earnings tend (over time, over time) to be reflected in the stock price. If they go up, the price will eventually reflect that.
Bonds are an IOU issued by a corporation, with a stated rate of return and a stated end date. Until that end date, bonds are legally obligated to pay the stated rate on a regular basis (typically twice a year).
Most other "investments" lack this yield feature. They are a zero-sum game: one person wins, another loses. There is no earnings engine behind copper, sugar, puts, or beanie babies. They require a "greater fool"; someone to pay you more than the thing has cost you. Maybe that person exists, maybe not. At all times, you need to consider that the greater fool is you. As they say in poker, if you look around the table and don't know who the sucker is, then it's you.
So, assuming you are interested in investing, why not buy stocks? Great fortunes have been made in them, and stock proponents just love to tout their long-term superiority over bonds. Just think of IBM, Microsoft and Google! Peter Lynch raved about ten-baggers (stocks that went up ten times from purchase to sale), and most stock brokers and investment advisors cite long-term returns for stocks over the past century (or whatever time period is most advantageous to their case) of 9-10%.
The problem is that this rosy figure is largely crap. The farther back you go, the greater the inaccuracy, due to the simple fact that the return is calculated from companies that still exist! All the ghosts (buggy whip makers, Grants, dozens of early computer makers, Enron, Bear Sterns, Lehman Brothers, Chrysler, and GM), and the huge fortunes they destroyed, are conveniently discarded from the computation. Yet real people owned those stocks, and their long-term results were severely degraded in the process. Don't forget, we've just completed an entire decade during which stocks went absolutely nowhere. That's zero return, before inflation (so really, a loss of principal)!
Now don't get me wrong. I actually think there is a case to be made for stocks, at least in theory. Just buy them when they're cheap. Spring of 2009 was a great time to do this. In fact, the best tool for identifying such opportunities is hindsight. To quote Mark Twain (loosely): "Buy a nice little stock, wait till it goes way up, then sell it. If it doesn't go up, then don't buy it." That's a perfect way to describe the art of timing!
My point? Timing is very difficult. Most professionals fail miserably; why do you think you'll do better? I can't overstate this. PROFESSIONALS FAIL MISERABLY at the very thing they claim to do: outperforming a monkey. The monkey throws darts at a newspaper to pick stocks; a professional dredges through reams of statistics and charts to do it. They both achieve, in the aggregate, the same result. Of course, the monkey doesn't charge anything, and so is the better choice for picking a portfolio. I'm serious!
Sure, I know you worship the mega-monkeys: Peter Lynch, Warren Buffett, the Barron's round table sages, etc. But take 100 dart-throwers, and you will, after ten years, come up with one or two simian geniuses who have vastly outperformed the market. Would you bet on these super-chimps being next year's champs? Want a case in point? Bill Gross, legendary stock-picker for 15 years, just quit after five straight years of crappy results. He's highly apologetic, specifying his "mistakes." I disagree. The odds just caught up with another King Kong.
Am I saying the professionals are idiots? Not at all; in fact, the opposite. That's the problem. There are THOUSANDS of brilliant folks out there trying to out-psych each other. Chart-readers are divining mystical data trends; fundamentalists are analyzing cash flows, macro-guys are predicting the rise of China and fall of America, ad infinitum. Each one of them is bright. In the aggregate, though, they tend to cancel one another out. Burton Malkiel and his folks have it right. At any given point, the price of a stock or group of stocks represents pretty much everything that everybody knows. Good news is baked in for high-performers; disaster for laggards. You can make a guess, and be right, but don't assume it's because you were smart. The course of a stock, or a group of stocks, over a short period of time, is a random walk. In time, a stock, or a group of stocks, will move according to underlying value, but that movement is inherently unpredictable, as predictable value is always discounted in a stock's present price.
What to do with stocks? Well, forget timing, forget analysis. (Perhaps even forget stocks.) If you do choose to own them (and diversification is probably the best reason), then buy an index fund or ETF, invest regularly, and close your eyes. In twenty or thirty years, you'll probably be pleased. DON'T time the market, DON'T sell when you're discouraged, and DON'T double down when you're just made a killing. You'll do just as well as all the other patient monkeys, much better than most impatient monkeys, and much better than most professionals (who are, after all, a merely a subset of the second group).
Why does timing fail? It should be possible, right? Occasionally, there come times when things are OBVIOUSLY cheap (again, Spring 2009). They were cheap because people were scared, and so were you. Your brain told you that you couldn't miss, but your gut said things might get a lot cheaper. So, you did nothing. We all act like this, and in reverse when things are obviously expensive.
I do think there is an answer. When it's painful, it's probably the right thing to do. So, do something, but not so much that you can't sleep at night (perhaps with an Ambien, to be sure). You need to buy something when your gut tells you it might go to zero and your brain tells you it's a screaming bargain. You need to sell something when the id screams about losing out, while Mr. Brain is shrieking "nosebleed!". BUT, this simple answer is very difficult! Human nature being ... well, human, few people can time when timing is objectively feasible.
Is there an investment that can work better for real people? We come back to bonds. I like them a lot. There is an admirable simplicity to a bond, despite its reputation as arcane and complex. A bond has a beginning date, an end date, and a predictable income stream (the coupon) in between. A bond has a beginning price and an end price, which are usually the same. A typical bond will be issued at $1000, with a specific coupon rate (say 6.5%) and a maturity date (usually from one to thirty years). In this example, you will receive two payments of $32.50 a year. When the bond matures, you get that $1000 back. That's pretty simple, right? You know exactly how much money you're going to make, how long it will take to make it, and when you're going to get your entire investment back.
Of course, interest rates go up and down. Therefore, a bond must reflect those changes in the meantime. That 6.5% coupon was the going rate at the time of issue (for that maturity and credit quality). If the rate goes up to 7% for new bonds, then older ones will have their price adjusted so that they too yield about 7% to a buyer. So, the quoted price of your 6.5% bond will go down (perhaps to $928). Now its $65 of income is 7% of $928. This might cause you distress, and is the reason most experts are screaming that you shouldn't buy bonds now. You've "lost" $72, or 7.2% on a small upward movement (1/2%) in yield! True enough, but what happens if you do nothing? It's not a loss unless you take the loss. Hold the bond to maturity, and you get that $72 back, for sure. In fact, it really doesn't matter how low it goes, you WILL get the money back! That's huge. As opposed to stocks, there really is a "correct" price for a bond, at least eventually.
Are you interested now?
Update 11/2015. Well, now I can report on stock returns with another five years of perspective. In the commentary above, I mentioned that we had just completed a full decade of zero returns for stocks. Well, using a standard Dow calculator, it now appears that the return for the last FIFTEEN years has been 2.61%! Now fifteen years is a pretty long stretch for such crappy returns. It makes my most plain vanilla scenarios look absolutely world-beating!
Wednesday, October 20, 2010
Why me?
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