Later in Against the Gods, Peter Bernstein comes close to what I'll be writing about in my own book on income investing.
He points out that the volatility Harry Markowitz posits as equal to stock market risk does not matter to "For true long-term investors -- that small group of people like Warren Buffett who can shut their eyes to short-term fluctuations and who have no doubt that what goes down will come back up -- volatility represents opportunity rather than risk, at least to the extent that volatile securitites tend to provide higher returns than more placid securities."
In that sentence he cannot get away from a concern with market price. But he does mention his wife's late aunt who used to boast that she was his only in-law who never asked him what he thought the market was going to do.
"I didn't buy in order to sell," Bernstein quotes his aunt-in-law.
Most people don't understand this attitude -- but it's perfectly logical if you are buying to receive dividends for the rest of your life.
Then you don't need to care about the market price, as long as you continue to receive ever-incresing dividend checks every quarter.
Your only risk is the danger that the company will decrease, suspend or end its quarterly dividend payments.
dividends overcome volatility
dividends overcome volatility
Sunday, June 24, 2007
Volatility is a good proxy for risk only if you are a short-term investor
Against the Gods by Peter Bernstein is subtitled "The Remarkable Story of Risk" though this is somewhat clipped. Obviously, risk as danger is not something that has a story. The book is about the attitudes and techniques people take in facing risk.
We have always faced danger. But we couldn't always buy insurance.
When it comes to stock market investing, Bernstein does finally discuss the nature of risk, when writing about Harry Markowitz's famous paper Portfolio Selection.
Because Markowitz uses volatility as a "proxy" for risk, Bernstein writes. The vast majority of financial writing do not even realize that volatility is not risk per se.
So he does discuss whether or not volatility is a good proxy for risk, or whether there's a better way to deal with it. If you don't look upon volatility as itself dangerous to your money, then stock market investing is less risky than putting your money into
a certificate of deposite that is risky because of its low yield.
volatility does not equal risk
volatility does not equal risk
We have always faced danger. But we couldn't always buy insurance.
When it comes to stock market investing, Bernstein does finally discuss the nature of risk, when writing about Harry Markowitz's famous paper Portfolio Selection.
Because Markowitz uses volatility as a "proxy" for risk, Bernstein writes. The vast majority of financial writing do not even realize that volatility is not risk per se.
So he does discuss whether or not volatility is a good proxy for risk, or whether there's a better way to deal with it. If you don't look upon volatility as itself dangerous to your money, then stock market investing is less risky than putting your money into
a certificate of deposite that is risky because of its low yield.
volatility does not equal risk
volatility does not equal risk
Value investors exhibit Gambler's Fallacy
Peter Bernstein continues to raise interesting points in Against the Gods.
He writes about the concept of regression to the mean, and how this has worked as a system of investing for people such as Warren Buffett and other value investors. Although he doesn't mention it, it also explain the Dogs of the Dow technique (before it became well known.)
Not to mention the "magazine cover" effect. This is where people who make the covers of magazines in their fields for their accomplishments often go downhill afterward. SPORTS ILLUSTRATED has actually studied it, because there're numerous examples of players and teams who have never been so good as they were before making the cover of that magazine. One options guru I know of (you likely get mail order advertisements from him) uses magazine covers as a contrary indicator in his system. If a company or CEO makes the cover of a business magazine, it's time to dump the stock!
It also explain the Growth Trap as explained by Jeremy Siegel in his latest book The Future for Investors. When you pay a premium for a stock with great growth prospects, you don't do as well as you do when you put the same money into an investment that is not comparatively overpriced. He compares long term investments in IBM and Standard Oil, and in China and Brazil. (Yes, in the past Brazil has been the better long term investment despite all its political and economic problems and despite China's phenomenal growth -- keep that in mind the next time you get sales letters in the mail telling you that you're going to be poor if you don't invest in China and India.
However, keep in mind Bernstein's caution that it's not always easy to know where the mean is and when the regression will occur. People who invested in the stock market in 1930 because they thought the crash was over lost a lot of money.
In gambling circles, the belief that random results will soon revert to normal because they've been abnormal, is known as the Gambler's Fallacy.
A lot of people have lost a lot of money to casinos because they were sure the roulette's wheel long streak of red "had" to end on the next spin, or 7 had to come up, or the slot machine had to pay off . . .
regression to the mean
regression to the mean
He writes about the concept of regression to the mean, and how this has worked as a system of investing for people such as Warren Buffett and other value investors. Although he doesn't mention it, it also explain the Dogs of the Dow technique (before it became well known.)
Not to mention the "magazine cover" effect. This is where people who make the covers of magazines in their fields for their accomplishments often go downhill afterward. SPORTS ILLUSTRATED has actually studied it, because there're numerous examples of players and teams who have never been so good as they were before making the cover of that magazine. One options guru I know of (you likely get mail order advertisements from him) uses magazine covers as a contrary indicator in his system. If a company or CEO makes the cover of a business magazine, it's time to dump the stock!
It also explain the Growth Trap as explained by Jeremy Siegel in his latest book The Future for Investors. When you pay a premium for a stock with great growth prospects, you don't do as well as you do when you put the same money into an investment that is not comparatively overpriced. He compares long term investments in IBM and Standard Oil, and in China and Brazil. (Yes, in the past Brazil has been the better long term investment despite all its political and economic problems and despite China's phenomenal growth -- keep that in mind the next time you get sales letters in the mail telling you that you're going to be poor if you don't invest in China and India.
However, keep in mind Bernstein's caution that it's not always easy to know where the mean is and when the regression will occur. People who invested in the stock market in 1930 because they thought the crash was over lost a lot of money.
In gambling circles, the belief that random results will soon revert to normal because they've been abnormal, is known as the Gambler's Fallacy.
A lot of people have lost a lot of money to casinos because they were sure the roulette's wheel long streak of red "had" to end on the next spin, or 7 had to come up, or the slot machine had to pay off . . .
regression to the mean
regression to the mean
Stock prices are a random walk toward greater wealth
In another section of Against the Gods by Peter Bernstein, he discusses whether or not the stock market truly moves in a "random walk" -- if it does, the graph of the market should resemble a normal distribution, or bell curve.
He graphed the moves of the markets for every month for 70 years, and found that they did indeed resemble a normal distribution bell curve -- with two differences.
First, there is an upward bias. That is, the long run the stock market does go up. We know that. And it proves that capitalism works. Our free market economic system is, on the whole, creating wealth, and this is reflected in the stock market.
Second, the "long tail" at the left is much bigger than a strict normal distribution would call for. This means, paradoxically, that extreme market moves to the downside happen more frequent than is statistically probable. His graph would have included the 1973-1974 downturn and the October 1987 crash.
Short term market results are not predictable. Stock prices change as a result of new events and information, but these events are unpredictable. Therefore, they add up to a random walk that as Burton Malkiel has described moves upward in the long run, thanks to the wind of economic growth.
If you want steady Eddy market prices you have to go with something like Treasury Inflation Protection Securities that increase in value on a regular basis and also have the benefit of going up at the inflation rate.
random walk
random walk
He graphed the moves of the markets for every month for 70 years, and found that they did indeed resemble a normal distribution bell curve -- with two differences.
First, there is an upward bias. That is, the long run the stock market does go up. We know that. And it proves that capitalism works. Our free market economic system is, on the whole, creating wealth, and this is reflected in the stock market.
Second, the "long tail" at the left is much bigger than a strict normal distribution would call for. This means, paradoxically, that extreme market moves to the downside happen more frequent than is statistically probable. His graph would have included the 1973-1974 downturn and the October 1987 crash.
Short term market results are not predictable. Stock prices change as a result of new events and information, but these events are unpredictable. Therefore, they add up to a random walk that as Burton Malkiel has described moves upward in the long run, thanks to the wind of economic growth.
If you want steady Eddy market prices you have to go with something like Treasury Inflation Protection Securities that increase in value on a regular basis and also have the benefit of going up at the inflation rate.
random walk
random walk
Nifty Fifty means you can overpay for growth stocks
Against the Gods by Peter Bernstein continues to contain a lot of concepts that are enlightening me in my research on investing for income.
He discusses Daniel Bernoulli and the Petersburg Paradox, where Peter tosses a coin until it turns up heads. For every toss of tails, Paul must pay Peter a number of ducats doubled from the previous toss. That is, 1,2,4, and so on into infinity. The expected value of being Peter is infinite, but nobody would pay that.
Then he transitions into the late 1960s and early 1970s when it seemed like the Nifty Fifty stocks were going to go up to infinity, and investors bought their shares as though they were worth any amount up to infinity. As though the real risk was in not owning shares in these stocks rather than in owning them, no matter how expensive.
If you know any stock market history, you know what happened. The market crashed in 1973 and hit terrible lows in 1974. The Nifty Fifty fell even farther than other stocks, since they had farther to fall. They did not surpass their December 1972 peaks again until July 1980.
Yet he also points out that they were good stocks and if you'd bought them at reasonable prices and just held on for the long run, you'd have made good money. They didn't grow into infinity, but they did have good growth prospects.
Bernstein doesn't mention this, but I suspect that their dividends made them worth holding on to. The real risks were in paying too high a price for the income stream and in selling those stocks when the prices were low.
Nifty Fifty
Nifty Fifty
He discusses Daniel Bernoulli and the Petersburg Paradox, where Peter tosses a coin until it turns up heads. For every toss of tails, Paul must pay Peter a number of ducats doubled from the previous toss. That is, 1,2,4, and so on into infinity. The expected value of being Peter is infinite, but nobody would pay that.
Then he transitions into the late 1960s and early 1970s when it seemed like the Nifty Fifty stocks were going to go up to infinity, and investors bought their shares as though they were worth any amount up to infinity. As though the real risk was in not owning shares in these stocks rather than in owning them, no matter how expensive.
If you know any stock market history, you know what happened. The market crashed in 1973 and hit terrible lows in 1974. The Nifty Fifty fell even farther than other stocks, since they had farther to fall. They did not surpass their December 1972 peaks again until July 1980.
Yet he also points out that they were good stocks and if you'd bought them at reasonable prices and just held on for the long run, you'd have made good money. They didn't grow into infinity, but they did have good growth prospects.
Bernstein doesn't mention this, but I suspect that their dividends made them worth holding on to. The real risks were in paying too high a price for the income stream and in selling those stocks when the prices were low.
Nifty Fifty
Nifty Fifty
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