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WSJ: Keep Your Money in the Market (Op-Ed by Malkiel)


techboy

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Good piece by Burton Malkiel, professor of economics at Princeton: Keep Your Money in the Market

As the world economy reels under the weight of the worst financial crisis since the Great Depression, we have been left with a broken financial system. Financial institutions around the world have suffered life-threatening, self-inflicted wounds by purchasing over a trillion dollars of complex mortgage-backed securities backed by dodgy loans based on inflated real-estate values. These assets have been financed with enormous leverage and with short-term debt. Just prior to its "rescue," Bear Stearns had a debt to equity ratio of over 30 to 1, making it susceptible to a "run on the bank," although Bear was not a commercial bank but rather part of the "shadow banking system" built on derivatives.

The long-run solution to the present crisis must involve substantial deleveraging and a recapitalization of our financial institutions. In the meantime, credit has been essentially frozen and a world-wide recession seems almost inevitable.

But just because stock markets have panicked, investors should not. The best position for investors today is not "fetal and 100% in cash." We are not going to have a depression, and we have survived financial crises before. A century of investing experience, as well as insights from the field of behavioral finance, suggest that investors who bail out of equities during times like these are almost always making the wrong decision.

It is very tempting to try to time the market. We all have 20/20 hindsight. It is clear that selling stocks a year ago would have been an excellent strategy. But neither individuals nor investment professionals can consistently time the market. The herd instinct is extraordinarily powerful. When the economy and the stock market were booming in early 2000, investors could easily convince themselves that prosperity would continue without interruption and that stocks catering to the "New Economy" were surefire tickets to wealth. Individuals poured more money into equity mutual-funds during the last quarter of 1999 and the first quarter of 2000 than ever before. And not only was the timing wrong but so was the selection of funds. The money flow was directed to the hot Internet funds. Investors liquidated "value" funds that owned less exciting businesses, whose stocks sold at only modest multiples of their earnings and book values.

The herd instinct works exactly the same way in bear markets. Nervous investors convince themselves that every "light at the end of the tunnel" is a train coming in the opposite direction. Panic is just as infectious as blind optimism. During the third quarter of 2002, which turned out to be the bottom of a punishing bear market, investors redeemed their mutual funds in droves. My own calculations show that in the aggregate, investors who moved money in and out of equity mutual-funds underperformed the buy-and-hold investors by almost three percentage points per year during the 1995-2007 period.

Look at history: The market eventually bounded back from the damaging stagflation of the 1970s and the savings-and-loan crisis of the early 1990s, when a whole industry had to be rescued. Stocks also recovered from the Asian crisis of the late 1990s. Similarly, investors who held on after the more than 20% one-day stock-market decline in 1987 were eventually well rewarded.

So what should investors do? By all means, young 401(k) investors, and those in their prime earnings years, who are stashing away funds from every monthly paycheck, should stay the course. If you decide to eschew equities during periods of ubiquitous pessimism, you will lose all of the advantage of "dollar cost" averaging (buying more shares when prices are low than when they are high). Asset allocations should be shifted to safer securities over time as the investor ages, but only gradually and on a set schedule as through a "target maturity fund."

If you are now approaching retirement and failed to move to a more conservative asset allocation, you should not do so now in response to a time of panic. If anything, well diversified investors should, at the end of each year, consider rebalancing to ensure that your portfolio composition remains consistent with the risk level appropriate for your financial circumstances and tolerance for risk. But this is likely to mean shifting into equities and not out of them.

Suppose you started the year with a portfolio of half stocks and half Treasury bonds. You are likely to find that the value of your bonds has gone up, as Treasury yields have fallen, and your stock portfolio has declined. Suppose the allocation at rebalancing time is two-thirds bonds and one-third stocks. The appropriate strategy is then to sell safe bonds and buy more equities to bring the stock/bond ratio back to 50%. Over the past decade, rebalancing a 50-50 portfolio each year has added to investors' returns and reduced risk.

We will have a serious recession now, but a 1930s-style depression is highly unlikely. We will not let the money supply decline by 25%, as we did in the '30s, and automatic stabilizers (like unemployment insurance) are now a significant element of fiscal policy. Don't forget that the U.S. economy is still the most flexible in the world and our "innovation machine" is alive and well.

No one has consistently made money by selling America short, and I am confident the same lesson is true today.

Emphasis mine.

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This one has been going around:

Once upon a time in a village, a man appeared and announced to the villagers that he would buy monkeys for $10 each. The villagers seeing that there were many monkeys around, went out to the forest, and started catching them. The man bought thousands at $10 and as supply started to diminish, the villagers stopped their efforts. The merchant further announced that he would now buy at $20. This renewed the efforts of the villagers and they started catching monkeys again. Soon the supply diminished even further and people started going back to their farms. The offer increased to $25 each and the supply of monkeys became so little, that it was a rare event to even see a monkey, let alone catch it!
The businessman now announced he would buy monkeys at $50! However, since he had to go to the city on some business, his assistant would now buy on his behalf.In the absence of the monkey dealer , the assistant told the villagers. “Look at all these monkeys in the big cage that my boss has collected. I will sell them to you at $35 and when he returns from the city, you can sell them back to him for $50 each. That’s a 44.1 percent markup!” The greedy villagers instantly agreed. They rounded up all of their savings and bought every single monkey inside the big cage. Then they never saw the monkey dealer nor his assistant again, only monkeys jumping everywhere!
Happy holding...
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This one has been going around:Happy holding...

Yeah... I think I prefer the expert opinion of a professor of economics at Princeton University over that of a chain e-mail, but thanks for sharing. :)

P.S. The fundamental flaw of the e-mail is that stocks (in the long run) have inherent value, while the monkeys in this story have none. I've already discussed with you why stocks are not a pyramid scheme, and you even agreed with me, so I'm not sure why you keep repeating this canard.

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Yeah... I think I prefer the expert opinion of a professor of economics at Princeton University over that of a chain e-mail, but thanks for sharing. :)

P.S. The fundamental flaw of the e-mail is that stocks (in the long run) have inherent value, while the monkeys in this story have none. I've already discussed with you why stocks are not a pyramid scheme, and you even agreed with me, so I'm not sure why you keep repeating this canard.

With the events going on Techboy, do you think we can use the history of the market to forecast future events and trends in this market

With the national debt only rising, and people's confidence in the markets clearly shaken up, are our ways of thinking about the market now obselete?

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TB, do you have a link to where you had this discussion with Ferg?

I'd be interested in a re-cap -- sounds like an interesting conversation.

Here. My first post is about halfway down. Fergusun "largely agrees" with me on page 5 (assuming default settings).

With the events going on Techboy, do you think we can use the history of the market to forecast future events and trends in this market?

No, I don't, because I don't think that anyone can correctly consistently forecast future events in the market.

Here's a more scholarly paper by professor Malkie:The Efficient Market Hypothesis and its Critics. I'll just quote the introduction:

A generation ago, the efficient market hypothesis was widely accepted by academic financial economists; for example, see Eugene Fama’s (1970) influential survey article, “Efficient Capital Markets.” It was generally believed that securities markets were extremely efficient in reflecting information about individual stocks and about the stock market as a whole. The accepted view was that when information arises, the news spreads very quickly and is incorporated into the prices of securities without delay. Thus, neither technical analysis, which is the study of past stock prices in an attempt to predict future prices, nor even fundamental analysis, which is the analysis of financial information such as company earnings, asset values, etc., to help investors select “undervalued” stocks, would enable an investor to achieve returns greater than those that could be obtained by holding a randomly selected portfolio of individual stocks with comparable risk.

The efficient market hypothesis is associated with the idea of a “random walk,” which is a term loosely used in the finance literature to characterize a price series where all subsequent price changes represent random departures from previous prices. The logic of the random walk idea is that if the flow of information is unimpeded and information is immediately reflected in stock prices, then tomorrow’s price change will reflect only tomorrow’s news and will be independent of the price changes today. But news is by definition unpredictable and, thus, resulting price changes must be unpredictable and random. As a result, prices fully reflect all known information, and even uninformed investors buying a diversified portfolio at the tableau of prices given by the market will obtain a rate of return as generous as that achieved by the experts.

The way I put it in my book, A Random Walk Down Wall Street, first published in 1973, a blindfolded chimpanzee throwing darts at the Wall Street Journal could select a portfolio that would do as well as the experts. Of course, the advice was not literally to throw darts but instead to throw a towel over the stock pages – that is, to buy a broad-based index fund that bought and held all the stocks in the market and that charged very low expenses.

By the start of the twenty-first century, the intellectual dominance of the efficient market hypothesis had become far less universal. Many financial economists and statisticians began to believe that stock prices are at least partially predictable. A new breed of economists emphasized psychological and behavioral elements of stock-price determination, and came to believe that future stock prices are somewhat predictable on the basis of past stock price patterns as well as certain “fundamental” valuation metrics.

Moreover, many of these economists were even making the far more controversial claim that these predictable patterns enable investors to earn excess risk-adjusted rates of return.

This paper examines the attacks on the efficient market hypothesis and the belief that stock prices are partially predictable. While I make no attempt to present a complete survey of the purported regularities or anomalies in the stock market, I will describe the major statistical findings as well as their behavioral underpinnings, where relevant, and also examine the relationship between predictability and efficiency. I will also describe the major arguments of those who believe that markets are often irrational by analyzing the “crash of 1987,” the “Internet bubble” of the fin de siecle, and other specific irrationalities often mentioned by critics of efficiency. I conclude that our stock markets are far more efficient and far less predictable than some recent academic papers would have us believe. Moreover, the evidence is overwhelming that whatever anomalous behavior of stock prices may exist, it does not create a portfolio trading opportunity that enables investors to earn extraordinary risk adjusted returns.

Emphases mine.

It's not just theory. Practical studies back this up. Here is one such: The Difficulty of Selecting Superior Mutual Fund Performance. The abstract:

-Much has been written about the management of mutual funds and active versus passive management. This study attempts to quantify the relative performance of actively managed large- and mid-cap domestic stock mutual funds with a passive strategy during a 20-year period, including 11 10-year rolling periods.

-During the study period, most actively managed large- and mid-cap mutual funds underperformed their respective passive strategies. While every period under review had mutual funds that outperformed the passive strategy, few funds did so consistently.

-Furthermore, predicting in advance which mutual funds would outperform was difficult, if not impossible, and the cost of selecting the "wrong" manager was high. These factors combined demonstrate the difficulty for financial planners to select superior performance.

-The study also reviewed the impact of taxes on large-cap investments.

Finally, the author provides recommendations for financial planners in discussing action steps regarding clients' portfolios.

Emphases mine. If anyone could predict the market, you'd think the pros could, yet there is no consistent pattern investors can benefit from.

My view is that the only ways to consistently guess what the market is going to do are to either 1) Possess insider information (illegal) or 2) be able to predict the future. Number 1 goes to jail, and number 2 should save some time and stick to lottery tickets. :)

(Yes, this stuff is all in the thread I linked to above).

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I do agree with you, but sometimes when I look at the history of Nikkei 225 I can't help but think we are looking at the future of the DJIA... buy and hold as killed all those Japanese who invested in the stockmarket. Although that is just looking at price and not taking into account dividend...

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I do agree with you, but sometimes when I look at the history of Nikkei 225 I can't help but think we are looking at the future of the DJIA... buy and hold as killed all those Japanese who invested in the stockmarket. Although that is just looking at price and not taking into account dividend...

Yes, and that's also assuming that they put their entire lump sum of savings in at the very peak, and didn't buy either before or after.

Still, the Nikkei is an excellent case in point of why stocks are risky, and should be held for the long term (like 20 or 30 years, at least).

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