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
Sunday, June 24, 2007
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
Wednesday, June 20, 2007
Risk and the utility of wins and losses
I've been reading Against the Gods by Peter Bernstein, which is about risk and how people have learned about probability, how to measure risk, and to some extent control it or use insurance to relieve it.
According to him, it was a man named Bernoulli who first articulated the idea of utility -- that is, that individual people put different emotional values on outcomes. A previous ancient writer said that people should not be so afraid of being struck by lightning, since it happened so rarely. Bernoulli said that people just put a higher emotional importance on the risk of being struck by lightning than of other, more common, dangers.
And Bernstein points out that human life would be a lot less rich if there weren't people who put a lot more value on the reward of taking a risk than they did on the loss they'd suffer from failing. Those are entrepreneurs, explorers and other pioneers who set out to accomplishment something (often at great cost) that is unlikely but which could bring great wealth.
It also explains why I play the lottery. The purely numbers-oriented people say, "The odds are 75 million against you, it's a scam." But I put a greater value on the (admittedly, highly unlikely) wealth I could win than the $2 I lose by playing.
If I didn't play, that $2 would just be absorbed into my daily cash budget, so it has a low utility to me. But I wouldn't have the right to dream of what I'd do if I won.
And who knows? Maybe someday I win. I know the odds are against me, but somebody eventually wins all the money. As long as I have a ticket, it could be me.
If someone has to beg for change on a streetcorner, then they should spend that $2 on the food they need to survive.
If you're depending on the lottery to make you wealth, you need to get off your butt and learn how to make, save and invest more money. You need to perhaps buy some government TIPS bonds to help your savings keep up with inflation.
But don't blame the lottery because some people who play it actually should use that $2 for some other purpose, or because they're too lazy or unambitious to work for wealth in other, more certain ways.
utility and risk
utility and risk
According to him, it was a man named Bernoulli who first articulated the idea of utility -- that is, that individual people put different emotional values on outcomes. A previous ancient writer said that people should not be so afraid of being struck by lightning, since it happened so rarely. Bernoulli said that people just put a higher emotional importance on the risk of being struck by lightning than of other, more common, dangers.
And Bernstein points out that human life would be a lot less rich if there weren't people who put a lot more value on the reward of taking a risk than they did on the loss they'd suffer from failing. Those are entrepreneurs, explorers and other pioneers who set out to accomplishment something (often at great cost) that is unlikely but which could bring great wealth.
It also explains why I play the lottery. The purely numbers-oriented people say, "The odds are 75 million against you, it's a scam." But I put a greater value on the (admittedly, highly unlikely) wealth I could win than the $2 I lose by playing.
If I didn't play, that $2 would just be absorbed into my daily cash budget, so it has a low utility to me. But I wouldn't have the right to dream of what I'd do if I won.
And who knows? Maybe someday I win. I know the odds are against me, but somebody eventually wins all the money. As long as I have a ticket, it could be me.
If someone has to beg for change on a streetcorner, then they should spend that $2 on the food they need to survive.
If you're depending on the lottery to make you wealth, you need to get off your butt and learn how to make, save and invest more money. You need to perhaps buy some government TIPS bonds to help your savings keep up with inflation.
But don't blame the lottery because some people who play it actually should use that $2 for some other purpose, or because they're too lazy or unambitious to work for wealth in other, more certain ways.
utility and risk
utility and risk
Tuesday, June 19, 2007
Income Investing Today - new book
Income investing is becoming a more popular subject. I just found another hardcover book devoted to it in the bookstore today -- Income Investing Today by Richard Lehman. I've got it on order from Amazon and can't wait to read.
Obviously there are many people looking for an alternative place to put their money besides a passbook account in a bank or chasing "growth" stocks that often don't grow - or which soon pop like a balloon.
My only concern is that, from flipping through it, it's obvious that he comes from a fixed income background -- although he prefers to avoid that phrase -- and so focuses on various securities besides dividend-paying stocks. This puts your portfolio at risk from inflation.
Still, it takes dividend-paying stocks years to catch up and then surpass the higher fixed income securities, and money in the present and near-term is worth more than a money in later years.
Income Investing Today
Income Investing Today
Obviously there are many people looking for an alternative place to put their money besides a passbook account in a bank or chasing "growth" stocks that often don't grow - or which soon pop like a balloon.
My only concern is that, from flipping through it, it's obvious that he comes from a fixed income background -- although he prefers to avoid that phrase -- and so focuses on various securities besides dividend-paying stocks. This puts your portfolio at risk from inflation.
Still, it takes dividend-paying stocks years to catch up and then surpass the higher fixed income securities, and money in the present and near-term is worth more than a money in later years.
Income Investing Today
Income Investing Today
Sunday, June 17, 2007
Asset allocation period for rebalancing advice is poort
However, something about the how-to information on asset allocation in both books disturbed me even more than one writer wanting to see patterns in short-term random results.
The advice about rebalancing.
Both of them say that after a period of time you should rebalance your portfolio, selling the assets which have most risen in price and buying more of the assets which have risen the least (or fallen!).
There is no clear cut consensus on how often you should do this, nor even any guidelines. The books mention periods of one year, quarterly, monthly and even weekly -- but leave it up to the reader.
This seems to me an incredible weakness, for several reasons:
1. Using a short period means you have little opportunity to take advantage of long term trends. For example, if you'd started an asset allocation program in 1995 would it have made much sense to sell off all your stocks in 1996? That bull market ran through March 2000.
Also, bear markets can go on for a long time. Some asset allocation programs contain gold. If you'd started an asset allocation program in 1981, your portfolio would by now consist almost entirely of gold . . . how happy would you be about that?
2. If your accounts are not tax-sheltered, you're realizing taxable capital gains, so part of your portfolio's gains are going to the government.
Even tax-sheltered accounts will have increased transaction costs. Brokerages like to rebalance client accounts every quarter. I wonder why they do it so often?
Seems to me that a poor asset allocation program is little better than an HYIP con game.
asset allocation rebalancing flaws
asset allocation rebalancing flaws
The advice about rebalancing.
Both of them say that after a period of time you should rebalance your portfolio, selling the assets which have most risen in price and buying more of the assets which have risen the least (or fallen!).
There is no clear cut consensus on how often you should do this, nor even any guidelines. The books mention periods of one year, quarterly, monthly and even weekly -- but leave it up to the reader.
This seems to me an incredible weakness, for several reasons:
1. Using a short period means you have little opportunity to take advantage of long term trends. For example, if you'd started an asset allocation program in 1995 would it have made much sense to sell off all your stocks in 1996? That bull market ran through March 2000.
Also, bear markets can go on for a long time. Some asset allocation programs contain gold. If you'd started an asset allocation program in 1981, your portfolio would by now consist almost entirely of gold . . . how happy would you be about that?
2. If your accounts are not tax-sheltered, you're realizing taxable capital gains, so part of your portfolio's gains are going to the government.
Even tax-sheltered accounts will have increased transaction costs. Brokerages like to rebalance client accounts every quarter. I wonder why they do it so often?
Seems to me that a poor asset allocation program is little better than an HYIP con game.
asset allocation rebalancing flaws
asset allocation rebalancing flaws
Asset allocation assets exhibit random covariance
Recently I read several books on asset allocation. This is not a full review of them, but I did notice several disturbing points.
One of the books wrote a lot about the variance between difference types of assets, such as stock and bonds. This variance is a critical point for asset allocation, because the theory behind it, Modern Portfolio Theory, comes from Harry Markowitz's work showing that overall portfolio risk is reduced by holding assets that don't go up and down in tandem.
Anyway, the book went on at length about how tricky this is, because the variance of stocks and bonds changes over time, and came up with different variances over 3 year periods in the past.
I had one of those flashes -- and it goes like this.
The stock market moves in a random walk.
The bond market moves in a random walk.
Therefore, whether stocks and bond prices go in different directions through various 3 years periods is . . . ta! da! --
Random.
I mean, at any given moment either market go only be going up, down or sideways. Therefore, sometimes they'll go in the same direction, sometimes they won't.
Yet this book wants you to adjust your allocation periodically on the basis of these random moves.
Look, the whole idea is that you're reducing risk because these two markets both are random, but can go in different directions. But it's obvious that sometimes they'll go in the same direction.
If you want uniformity, put your money in a passbook savings account in a bank.
asset allocation illusion
asset allocation illusion
One of the books wrote a lot about the variance between difference types of assets, such as stock and bonds. This variance is a critical point for asset allocation, because the theory behind it, Modern Portfolio Theory, comes from Harry Markowitz's work showing that overall portfolio risk is reduced by holding assets that don't go up and down in tandem.
Anyway, the book went on at length about how tricky this is, because the variance of stocks and bonds changes over time, and came up with different variances over 3 year periods in the past.
I had one of those flashes -- and it goes like this.
The stock market moves in a random walk.
The bond market moves in a random walk.
Therefore, whether stocks and bond prices go in different directions through various 3 years periods is . . . ta! da! --
Random.
I mean, at any given moment either market go only be going up, down or sideways. Therefore, sometimes they'll go in the same direction, sometimes they won't.
Yet this book wants you to adjust your allocation periodically on the basis of these random moves.
Look, the whole idea is that you're reducing risk because these two markets both are random, but can go in different directions. But it's obvious that sometimes they'll go in the same direction.
If you want uniformity, put your money in a passbook savings account in a bank.
asset allocation illusion
asset allocation illusion
Tuesday, June 12, 2007
No level playing field for individual investors aiming for capital gains
Last night I began re-reading CAPITAL IDEAS by Peter Bernstein and suddenly he gave away an important clue about why individual investors such as you and I are at a disadvantage when it comes to trying to beat the stock market.
He mentioned how much the market's volume has gone from being transactions by individual investors to transactions by funds - pension funds, mutual funds, endowment funds and charitable funds. And he casually mentioned how these were tax-free -- that is, free of all capital gains taxes. He repeated this again a page or two later.
The proverbial light bulb went off over my head. No capital gains taxes! Say what?
I don't know about you, but I never knew that before. To tell the truth, I'd never thought about these funds paying capital gains taxes. I just assumed they did.
I can understand why the government allows them to sell securities without paying capital gains taxes, but it still puts you and I at a significant disadvantage relative to these institutions, when you and I try to compete as stock pickers.
We have to pay capital gains taxes. That's a significant drag on the long term performance of any person buying and selling stock. It's why Warren Buffett's favorite holding period is "forever."
So by not having to pay it, these institutions are making decisions free of a major constraint that we face.
This is a major factor in the stock market -- and nobody's talking or writing about it.
So it's one more good reason why we should be investing for income, not capital gains. Because if we play the buy stocks now so they'll go up and we sell them at a profit game, we're competing against major institutions and fund managers who not only have tremendously more resources (including their time) than we have -- but they don't have to pay capital gains taxes, as we do.
Don't pay capital gains taxes, yet enjoy a cash return from your investments -- buy securities for income, and never sell them.
capital gains disadvantage
capital gains disadvantage
He mentioned how much the market's volume has gone from being transactions by individual investors to transactions by funds - pension funds, mutual funds, endowment funds and charitable funds. And he casually mentioned how these were tax-free -- that is, free of all capital gains taxes. He repeated this again a page or two later.
The proverbial light bulb went off over my head. No capital gains taxes! Say what?
I don't know about you, but I never knew that before. To tell the truth, I'd never thought about these funds paying capital gains taxes. I just assumed they did.
I can understand why the government allows them to sell securities without paying capital gains taxes, but it still puts you and I at a significant disadvantage relative to these institutions, when you and I try to compete as stock pickers.
We have to pay capital gains taxes. That's a significant drag on the long term performance of any person buying and selling stock. It's why Warren Buffett's favorite holding period is "forever."
So by not having to pay it, these institutions are making decisions free of a major constraint that we face.
This is a major factor in the stock market -- and nobody's talking or writing about it.
So it's one more good reason why we should be investing for income, not capital gains. Because if we play the buy stocks now so they'll go up and we sell them at a profit game, we're competing against major institutions and fund managers who not only have tremendously more resources (including their time) than we have -- but they don't have to pay capital gains taxes, as we do.
Don't pay capital gains taxes, yet enjoy a cash return from your investments -- buy securities for income, and never sell them.
capital gains disadvantage
capital gains disadvantage
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