Today's Market
by Dr Invest

I strongly encourage you to move to the SIDEBAR and select KNOWLEDGE BASE & BOOKS. Look for Charles Ellis and "The Loser's Game". Reading this article will benefit you greatly. Below

Here is how Charles Ellis describes the investment “loser’s game”:

For professional investors, “the ‘money game’ we call investment management evolved in recent decades from a winner’s game to a loser’s game because a basic change has occurred in the investment environment: The market came to be dominated in the 1970s and 1980s by the very institutions that were striving to win by outperforming the market. No longer is the active investment manager competing with cautious custodians or amateurs who are out of touch with the market. Now he or she competes with other hardworking investment experts in a loser’s game where the secret to winning is to lose less than others lose.

Underperformance by Active Managers

Readers that have followed Investing Caffeine for a while understand how I feel about passive (low-cost do-nothing strategy) and active management (portfolio managers constantly buying and selling) – readDarts, Monkeys & Pros. Ellis’s views are not a whole lot different than mine – here is what he has to say while not holding back any punches:

The basic assumption that most institutional investors can outperform the market is false. The institutions are the market. They cannot, as a group, outperform themselves. In fact, given the cost of active management – fees, commissions, market impact of big transactions, and so forth-85 percent of investment managers have and will continue over the long term to underperform the overall market.

He goes on to say individuals do even worse, especially those that day trade, which he calls a “sucker’s game.”

Gaining an Unfair Competitive Advantage

According to Ellis, there are four ways to gain an unfair competitive advantage in the investment world:

1) Physical Approach: Beat others by carrying heavier brief cases and working longer hours.

2) Intellectual Approach: Outperform by thinking more deeply and further out in the future.

3) Calm-Rational Approach: Ellis describes this path to success as “benign neglect” – a method that beats the others by ignoring both favorable and adverse market conditions, which may lead to suboptimal decisions.

4) Join ‘em Approach: The easiest way to beat active managers is to invest through index funds. If you can’t beat index funds, then join ‘em.

The Case for Stocks

Investor time horizon plays a large role on asset allocation, but time is on investors’ side for long-term equity investors:

That’s why in the long term, the risks are clearly lowest for stocks, but in the short term, the risks are just as clearly highest for stocks.

Expanding on that point, Ellis points out the following:

Any funds that will stay invested for 10 years or longer should be in stocks. Any funds that will be invested for less than two to three years should be in “cash” or money market instruments.

While many people may feel stock investing is dead, Ellis points out that equities should return more in the long-run:

There must be a higher rate of return on stocks to persuade investors to accept risks of equity investing.

The Power of Regression to the Mean

Investors do more damage to performance by chasing winners and punishing losers because they lose the powerful benefits of “regression to the mean.” Ellis describes this tendency for behavior to move toward an average as “a persistently powerful phenomenon in physics and sociology – and in investing.” He goes on to add, good investors know “that the farther current events are away from the mean at the center of the bell curve, the stronger the forces of reversion, or regression, to the mean, are pulling the current data toward the center.”

The Power of Compounding

For a 75 year period (roughly 1925 – 2000) analyzed by Ellis, he determines $1 invested in stocks would have grown to $105.96, if dividends were not reinvested. If, however, dividends are reinvested, the power of compounding kicks in significantly. For the same 75 year period, the equivalent $1 would have grown to $2,591.79 – almost 25x’s more than the other method (see also Penny Saved is Billion Earned).

Ellis throws in another compounding example:

Remember that if investments increase by 7 percent per annum after income tax, they will double every 10 years, so $1 million can become $1 billion in 100 years (before adjusting for inflation).

Home Sweet International Home

Although Ellis’s recommendation to diversify internationally is not controversial, his allocation recommendation regarding “full diversification” is a bit more provocative:

For Americans, this would mean about half our portfolios would be invested outside the United States.

This seems high by traditional standards, but considering our country’s shrinking share of global GDP (Gross Domestic Product), along with our relatively small share of the globe’s population (about 5% of the world’s total), the 50% percentage doesn’t seem as high at first blush.

REGRESSION TO MEAN

Hussman            http://www.hussmanfunds.com/wmc/wmc050222.htm

Let's look at the data. First, note that measured from peak-to-peak, S&P 500 earnings really have grown no faster than 6% annually over time. This is something to keep in mind when you hear that “earnings are growing at 18% annually,” etc. Those figures represent trough-to-peak recoveries from depressed levels, not sustainable earnings trends that are appropriate for valuing stocks over the long-term.

We can make our own chart following the 6% MEAN. The result is that the market is overvalued and overbought. Though the market could climb higher over the next few weeks, it would be challenging to keep that peak and the likely prediction is a regression to MEAN since we have reached peak to peak earnings. 

I encourage you to be careful with your investments. The good times can't continue to roll. 

(note: the above information is for entertainment purposes only and not to be used as investment advice. )