Asinine Theory Exposed by Octogenarian

Asinine Theory Exposed by Octogenarian

Link: David Atwood Blog – Speakeasy – Asinine Theory Exposed by Octogenarian

The emotional scars left by the twin beat downs of 2002-03 and 2008-09 are still healing, even though portfolios have rebounded “nicely” off of the bottom both times, and every time in history before that.

For those who may be suffering, the lingering damage to the psyche is often greater than the amount of the sustained physical loss. Here is why. Your, “once bitten, twice shy”, reflex may influence your future outcomes in ways that are far more costly than all of the financial damage you have ever sustained as an investor. You already know you can protect yourself; we’ve done that, so where do we go from here?

Let’s start with developing understanding as a first step toward accepting what has happened, if only because acceptance is the seed of recovery.

Keeping things in perspective, we got here mostly because the returns offered by guaranteed savings products are simply not enough to secure the kind of retirement that you are looking for. Your planning documents told us we need to do more right from the beginning. Most of us have to own equities if we are to have any chance at all of meeting our objectives. This is not a gamble on interest rates versus stock markets.

Okay, so we know what we have to do. How does it work? Price and value are not an efficient frontier, perfectly aligned with one another as though everything that can be known is known, and prices are adjusted accordingly. Modern Portfolio Theory, where the efficient frontier is described in business school textbooks, is asinine according to 86 year old Charlie Munger. (Berkshire Hathaway AGM 2006 – Warren Buffett once described Munger as a genius on the scale of Sir Isaac Newton).

The factors causing prices to change often have little to do with the true underlying value. More often than not prices have been motivated by fear and greed, and lately those emotions are amplified by programed trading and automation. Within this dramatic volatility lays the opportunity.

In the short term, say 3-5 years or less, Mr. Market behaves like a voting machine as it would in a beauty contest, or for those with young children, as if a magic mirror on the wall. Every minute of every day Mr. Market offers the crown to the prettiest of them all. After a while, the fakes and story tellers are discovered and they disappear. It’s only over the long-term; say 5 to 10 years or more that the market behaves like a weighing machine, accurately returning a reliable measure of value.

As a long term investor, you could easily say that this past 10-12 years have not worked out as planned. Returns have fallen well below the long term average; prices don’t seem to be moving. As an example, during the period from June 28, 1999 to this past fall on October 3, 2011, the Dow Jones Industrial Average (DJIA), went from a level of 10,655.15 to 10,655.30. Not much of a move when you consider an 8% growth rate would have placed the index at over 26,831 during the same 12 year span. Why is this, you ask? It’s because of the weighing machine and the natural restoration of the price/value relationship.

Allow me to explain more clearly using historical facts which illustrate the same sort of challenge facing investors today. Between December 31, 1964 and December 31, 1981, the Dow Jones Industrial Average moved from 874.12 to 875. That isn’t a typo. During that 17 year period the economy was thriving, growing by about 370%, while the market went exactly nowhere. During the next 17 years, in almost biblical proportion, the economy actually cooled off growing by less than 300% while stock prices on the Dow grew from 875 to 9181. The period ending at December 31, 1998 returned investors a more than 10 fold increase or, an annualized return of 19%!

So what you have my friends, is a classic example of how the weighing machine works. Also you can see how there can be a disconnection between economic growth and stock market performance. What it also means is, there are times when sitting on your hands and making money can be one and the same, it’s when turkeys fly in a windstorm. Also, there are other times, such as the present, where a more active approach is needed not so much to manage risk, but to capitalize on the opportunity.

The best way to capitalize is using your free cash flow. In short, it means take advantage while you still can to load up, and fill your boots! There is a big price to be paid for a cheery consensus. It is times like this that businesses are returned to their rightful owners. We’re here early for the next party weighing in; being fashionably late will come with a hefty price tag.

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