Monday, May 28, 2012

Blind Men And The Elephant & World War II


We began our studies of fundamental analysis, technical analysis and random walk theory over a year ago.  We have learned about each investment strategy, its core beliefs and its suggested methods of profiting in the market.  The proponents of each form of investing not only tout the merits of their preferred method, but also spend almost as much time and effort denigrating the others.  I am reminded of the old parable about a group of blind men and an elephant which is found in Buddhist, Sufi Muslim, Hindu and other religious/philosophical writings.  

Supposedly originating in India centuries ago, the many versions of the basic story focus on either a number of blind men or several men in a completely dark room.  They are introduced to a king's elephant and given the task  of describing it using only the sense of touch.  The catch, of course, is that each individual can explore only one part of the animal and none of the men can touch the same part.  In each version of the parable, the men report to the king the results of their explorations.  The man who felt the leg describes the animal as a pillar; the man who grabbed the tail imagines the elephant as a rope;  the one who explored the trunk reports that the elephant is like a large tree branch.  Conflicting reports are also provided by the individuals who touched the stomach, an ear and a tusk.  The men argue about who is correct.  The king resolves the dispute by explaining that each of them is correct based on what they felt (their individual perspectives); however, none of them is totally correct.

Like the elephant and its many parts, the market has many different investments to offer to investors and speculators.  The investors and speculators also differ in many ways, but are the same in certain respects; each one has a goal, a preferred method of achieving that goal and a time frame within which to do so.  Depending on an investor's focus; how he or she chooses to invest, and the available time for investing, the individual may be correct, given the personal goal.  However, individual success does not necessarily require the blanket exclusion of other investment options or techniques under all other circumstances.

For example, a young person who is putting aside money regularly for retirement will, in all probability, invest with long term capital appreciation in mind, seeking to increase the amount of his or her retirement funds over time.  A person who is looking for a run of small profits may engage in what is called day trading where profits are measured in fractions of a dollar quickly gained.  A person who is nearing retirement may reduce the number of more speculative stocks he or she owns and convert them to more conservative holdings.  This person is giving up the chance for large gains in order to avoid untimely losses.  Someone who has retired may be looking for a reliable income stream to support his or her desired lifestyle.  A retiree may sell some stocks previously held for appreciation and invest the proceeds in stocks paying steady, safe dividends.

Given their divergent goals, does it make any sense for the young day trader to criticize the dividend strategy of the retiree?  Should the technical analyst seeking to predict the projected movement of a stock over the next several months scoff at the multi-year strategy of the long term value investor?

Think of World War II as an analogy for the market.  This global conflict was fought throughout Europe, Africa, Russia, the Far East and the Pacific Islands.  The tactics and equipment used by the opponents were not the same in the Ardennes forests, the African deserts, the City of Stalingrad, the Burmese jungles or the islands dotting the Pacific.  Each side and their armies had the same ultimate goal, victory.  The strategies, tactics and maneuvers with which they went about it depended on who, where, when and how the opposing forces met in combat. In a similar fashion, investors come to the market with the same goal, profit.  As with those armies, the investors' strategies, tactics and investing maneuvers will be based on how they see profits can be made in the time period they have available to them.

In the next blog we will look at the differences between individual investors, the so called amateurs, and Wall Street professionals.

Comments are always welcome.

Monday, May 21, 2012

Some Final Random Thoughts (5)


Many years ago, my three children were watching television shortly after we had signed up for cable service.  One of the kids' channels back then was Nickelodeon.  I remember all three of them rushing up to me yelling that the TV was broken.  When I asked them what was wrong, they breathlessly reported that, most importantly, they hadn't done anything to the TV set or the remote control and that there was no color on the picture.  Not necessarily buying their story that they had done nothing wrong, I went to investigate.  I started laughing when I realized that the program they were watching was an old show from the 1950s.  Their jaws dropped when I informed them that the show was one I had watched when I was a child, and that there were no television shows in color at that time.  They were so shocked at this news that, at first, I don't think they really believed me.  We had to alternate between several channels, flipping back and forth between color programming and the old black and white broadcast before they accepted the idea.

I assume older investors (I count myself as one of them) can remember the days before index funds, but younger investors might be surprised to learn that one of the most popular types of mutual funds today, the S&P 500 index fund, is not yet 40 years old.  Our old friend Adam Smith wrote several books in addition to his classic, The Money Game.  One of them, Super-Money, was published in 1972.  In that book, he chronicled several studies at the time which concluded that market averages such as the S&P 500 beat the performance of most professionally managed mutual funds a majority of the time.  The question was how to obtain these results without having to buy all 500 stocks.  Mr. Smith wrote the following:

Of course, you cannot buy a statistically random portfolio, even though your portfolio may have a very random look about it.  And you cannot really buy the Dow Jones average or the Standard & Poor.  If you are going to buy a fund -- or the equivalent slice in a bank-managed common trust -- you have to buy that, and you hope that your fund or your banker is at the top of the list, helping the team against the randoms, and not at the bottom.*

About the same time, Professor Burton Malkiel wrote his first of ultimately ten editions of A Random Walk Down Wall Street and joined Adam Smith's lament as follows:

What we need is a no-load, minimum management-fee mutual fund that simply buys the hundreds of stocks making up the broad stock-market averages and does no trading from security to security in an attempt to catch the winners.  Whenever below-average performance on the part of a mutual fund is noticed, fund salesmen are quick to point out "You can't buy the averages."  It's time the public could.**

An S&P 500 index fund buys the stocks that make up the index in the same percentages as exist in the index.  If, say, IBM represents 5% of the index, then it will be 5% of the fund's stock holdings.  The value of the fund moves in lock step with the index itself, and the stocks held in the fund are changed only when a company is removed from the index and a new company replaces it.

Two banks, Wells Fargo and American National Bank in Chicago, offered such index funds to their institutional clients in 1973.  John Bogle, the founder of investment giant Vanguard Group, was the first to offer an index fund holding the S&P 500 stocks to the investing public in 1975. When it started, the index fund attracted $11 million, which was then, and still is, considered a pittance.  Twenty-four years later, 1999, that index fund had grown to $50 billion.  Combined, Vanguard's family of funds totaled $100 billion that year.   Investors who did not want to pick individual stocks for their portfolio understood that they could inexpensively harness the random movements of the stock market and match its annual averages.  They flocked to the fund.  Today most investment companies include an S&P 500 Index fund in their investment offerings.

Like many investment strategies before it, the Random Walk theory has faded in popularity in recent years.  However, the investment product it generated, the index fund, is alive and well on Wall Street.

*  Excerpt from Super-Money by Adam Smith, copyright 1972, published by Fawcett Popular Library, page 95.

**  Excerpt from A Random Walk Down Wall Street, by Burton Malkiel, copyright 1972, published by W.W. Norton, pages 226-227.

Comments are always welcome.

Monday, May 14, 2012

More Random Thoughts (4)


One of the main tenets of the Efficient Market Hypothesis (Random Walk) is the assumed rationality of an investor in the market.  Economists refer to this creature as the "utility-maximizing agent."   I'm not sure I really understand it, but I think what they mean is that people will always act in an economically reasonable manner in light of the circumstances they face.  Many who criticize the academics for their Random Walk theory point to the people in Holland in the 1600s who were caught up in what is popularly called the tulip bulb craze.  We read Charles Mackay's 1841 description of this investment boom/bubble in an earlier blog.

Professor Robert J. Shiller, a Yale economics professor and author, discussed the tulip bubble in his 2000 book, Irrational Exuberance, and argued that it  was not necessarily an example of irrational behavior as follows:

But Mackay offered no concrete evidence that people were behaving insensibly and moreover could not show that the rage had anything to do with any speculative mispricing.  Garber (Peter Garber is an economics researcher and author) points out that the really high prices were for rare varieties of tulips that had unusual patterns of coloration due, we now know, to infection by a mosaic virus.  These tulips could not be readily propagated and were genuinely rare.  People in Holland at the time highly valued these unusual tulips, which had great significance in their culture.  Thus there is nothing more foolish about their high tulip prices than about the high prices that rare art objects or other collectibles often fetch today.  Moreover, the price behavior of the tulip bulbs looks rather like that of the prices of many other speculative assets; they did not boom once, crash once, and then stay down as some simpler stories suggest.  Prices of tulips went up and down numerous times, just as stock prices do all the time.  These price changes could well have had some rational basis in new information about public demand for rare flowers becoming known to investors over time.*

In 1940 author Fred Schwed, Jr. wrote a hilarious account of Wall Street titled, Where Are the Customer's Yachts? or A Good Hard Look At Wall Street.  It is said that he worked on Wall Street for only a couple of years in the 1920s, but he apparently figured out its foibles and eccentricities in that short time.  As Schwed saw it, there were not that many "utility maximizing agents" on the Street when he was there.  He summarized Wall Street's appetite for market booms as follows:

In attempting to find out just what, if anything, was good in the good old days it is necessary to determine when the good old days were.  In some simple, but not straightforward, Wall Street minds, they were any days that preceded the Securities and Exchange Commission, when there weren't no ten commandments and a man could raise a thirst.  Oh for the days when the most important rules were "Don't rebate on commissions," "Don't shoot the specialists," and "Don't smoke opium on the floor during trading hours."

It would be more correct and more honest to recognize that the good old days were simply boom days, like the booms of the late twenties, the late teens and the late nineteenth century.

In our moments of sober thought we all realize that booms are bad things, not good.  But nearly all of us have a secret hankering for another one.  "Another little orgy wouldn't do us any harm," is the feeling that persists both downtown and up.  This is quite human, because in the last boom we acted so silly.  If we are old enough we probably acted silly in the last three.  We either got in too late, or out too late, or both.  But now that we are experienced, just give us one more shot at a good reliable runaway boom!**

It seems to me that the answer to whether the market is rational/efficient or irrational/inefficient may be based simply on your personal beliefs about the subject.  Ample evidence would appear to be available to buttress either position.

We will conclude our look at Random Walk in the next blog.

*  Excerpt from SHILLER, ROBERT J.; IRRATIONAL EXUBERANCE, copyright 2000 Robert J. Shiller, published by Princeton University Press, reprinted by permission of Princeton University Press. 

**  Excerpts from Where Are the Customer's Yachts? or A Good Hard Look At Wall Street, Fred Schwed, Jr., copyright 1940, republished by John Wiley & Sons, Inc, pages 148-149.

Comments are always welcome.

Monday, May 7, 2012

Burton Malkiel - Random Thoughts (3)


Professor Burton G. Malkiel wrote his classic, A Random Walk Down Wall Street, in 1973.  The tenth edition of the book was published this year, a long term testament to its relevance not only 39 years ago, but also today.

He described the general theory supporting Random Walk (also known as the Efficient Market Hypothesis  "EMH") as follows:

A random walk is one in which future steps or directions cannot be predicted on the basis of past actions.  When the term is applied to the stock market, it means that short-run changes in stock prices cannot be predicted.  Investment advisory services, earnings predictions, and complicated chart patterns are useless.  On Wall Street, the term "random walk" is an obscenity.  It is an epithet coined by the academic world and hurled insultingly at the professional soothsayers.  Taken to its logical extreme, it means that a blindfolded monkey throwing darts at a newspaper's financial pages could select a portfolio that would do just as well as one carefully selected by the experts.*

As is so often the case, a general theory becomes divided into subsets, each one addressing separate issues.  The academics attacked both the fundamental and the technical forms of investing.  Professor Malkiel explained the forms of Random Walk as follows:

The "narrow" (weak) form of the theory says that technical analysis --looking at past stock prices -- could not help investors.  The "broad" (semi-strong and strong) forms state that fundamental analysis is not helpful either:  All that is known concerning the expected growth of the company's earnings and dividends, all of the possible favorable and unfavorable developments affecting the company that might be studied by the fundamental analyst, is already reflected in the price of the company's stock.*

As you can well imagine, the Wall Street professionals did not react well to the academic criticism that their efforts were, essentially, worthless.  Bradbury K. Thurlow, in his book Rediscovering the Wheel: Contrary Thinking & Investment Strategy,  made what I consider a very measured argument against EMH as follows:

Indefinite, uncertain, wavering assumptions, constantly subject to change from unforeseen influences, are at best miserable companions to live with.  Unfortunately, they are the essential ingredients of speculative decisions.  Without them, the stock market would be totally efficient.  They are the measure of its inefficiency and our opportunity for profit.  Without them our activities would serve no purpose.**

It is a tribute to his fair mindedness that Mr. Thurlow went on to acknowledge the following:

In the years 1973-1977 it is noteworthy that the median performance out of the largest 500 issues was better than three out of four professional money managers.  Over such a five year period a chimpanzee with enough darts should be able to achieve at least a random performance, which, in theory should qualify him for a six-figure income as one of the nation's proven top money managers.**
(Author's emphasis in bold) 

We will continue our look at Random Walk in the next blog.

Excerpts from A Random Walk Down Wall Street by Burton G. Malkiel, copyright 2012, 2011, 2007, 2003, 1999, 1996, 1990, 1985, 1981, 1975, 1973 by W.W. Norton & Company, Inc are used with permission of W.W. Norton & Company, Inc.

**  Excerpts from Rediscovering the Wheel: Contrary Thinking & Investment Strategy, Bradbury K. Thurlow, ©1981, published by Fraser Publishing Company, are used by permission of the current copyright holder.

Comments are always welcome.