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“Ignorance is bliss” – American proverb
In 2002, Daniel Kahneman, an Israeli-American, won the Nobel Prize in Economics for his ground-breaking work in behavioral finance. During last prolonged bear market, the Israeli Pension Authority came to him with an all too common problem. Pensioners kept changing their investment allocations according to prevailing market conditions. These frequent changes not only were unhelpful for the long term, but also added costs to pension management. Kahneman gave them one simple solution: send the pensioners statements quarterly instead of monthly.
How can it help to know less about your investment performance?
I studied all seven bear markets since 1970 and calculated their peak-to-trough drawdowns (a reduction in account equity) from the perspective of four different types of investors:
- A: Investors who check their accounts intra-daily
- B: Investors who check their accounts monthly
- C: Investors who check their accounts quarterly
- D: Investors who check their accounts annually
Here are the results:
| S&P 500 | Peak to trough drawdown | ||||||
| Peak date | Peak | Trough date | Trough | A | B | C | D |
| 3/24/2000 | 1552.87 | 10/9/2002 | 768.63 | -51% | -46% | -46% | -40% |
| 7/17/1998 | 1190.58 | 10/8/1998 | 923.32 | -22% | -10% | -10% | 0% |
| 7/16/1990 | 369.78 | 10/17/1990 | 294.54 | -20% | -15% | -15% | -7% |
| 8/25/1987 | 337.89 | 12/4/1987 | 221.24 | -35% | -30% | -23% | 0% |
| 11/28/1980 | 141.96 | 8/12/1982 | 102.2 | -28% | -24% | -19% | -10% |
| 9/21/1976 | 108.72 | 3/6/1978 | 86.45 | -20% | -17% | -15% | -12% |
| 1/5/1973 | 121.74 | 10/3/1974 | 60.96 | -50% | -46% | -46% | -42% |
Two observations emerge from this study:
- Regardless of the cyclic nature of bull and bear markets, the S&P 500 index keeps marching upward. (You don’t want to stop that march!)
- The more frequently you check your accounts, the more painfully you feel (and probably will react to) a bear market.
Take the bear market in 1987 for example; the intra-day peak-to-trough drawdown was 35%. For type C investors who checked their accounts quarterly, the drawdown was only 23%. Type D investors who checked their accounts annually would not feel the pain at all since the bear market began and ended within the year. Who would be more likely to stay the course? Go figure!
The author is president of MZ Capital, a RIA serving DC/MD/VA. Get his monthly newsletter in your mailbox or get to the directory of his past articles.
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July 2008 marks the start of a bear market after all major market indices have fallen more than 20% from their most recently peaks. This article is part two of my three-part research on bear markets. In part one, I researched how long a typical bear market lasts?. In this installment I ask this question:
Which style fared the best in a one-year time frame after stocks have entered a bear market?
There are four primary styles of stock investing: Small Cap Value (SV), Small Cap Growth (SG), Large Cap Value (LV), and Large Cap Growth (LG). Typically, before stocks enter into a bear market, Small Cap stocks, regardless of value or growth, get hit the hardest.
Using data provided by Fama/French benchmark style portfolios, I calculated one-year returns of the four investment styles from the month stocks entered a bear market. The results are tabulated below.
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Bear market: how long will it last?
Posted on: July 30, 2008
It’s official. On July 9, US stocks slid more than 20% from their October high, sending the S&P 500 into bear market territory. Even earlier this month the NASDQ and Dow Jones turned bearish following the Russell 2000, an index of small caps, which lead the decline.
How long will this bear market last?
Well, I don’t have a crystal ball, but I do have a rear view mirror.
Since 1960, there have been ten bear markets (see Table). The worst bear market took one-and-a-half years to reach bottom. Four reached bottom within a month. The remaining five hit bottom between one and ten months. On average, it took 4 months to reach bottom.
| Date of entering bear market | Months to bear bottom | 1 year return from entry | 3 year return from entry |
| 2/26/2001 | 19 months | -11% | -8% |
| 10/8/1998 | < 1 months | 38% | 12% |
| 10/17/1990 | < 1 months | 33% | 59% |
| 10/19/1987 | 2 months | 3% | 13% |
| 3/1/1982 | 5 months | 34% | 63% |
| 3/6/1978 | < 1 months | 13% | 49% |
| 12/10/1973 | 10 months | -32% | 9% |
| 1/26/1970 | 4 months | 10% | 35% |
| 10/3/1966 | < 1 months | 28% | 24% |
| 5/28/1962 | 1 month | 20% | 51% |
| Average | 4 months | 14% | 31% |
Data source: Moneycentral.com
Now that we are in a bear market, shall we move to cash?
I don’t recommend it. Here’s why. From the day the S&P 500 entered a bear market, on average it returned 14% in one year and 31% in three years.
Let’s look at the distribution of returns. This is important. Among the ten one-year returns, two were negative, yet three were over 30%. As for the three-year returns, only one was negative but three were over 50%!
I don’t know about you, but I like those odds.
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Warren Buffet said: “Price is what you pay and value is what you get.”
Wall Street uses the price-to-earning ratio, or the P/E ratio in short, to determine whether one gets what one pays for when buying a stock. Is this ratio just a myth? Or is it a useful valuation measure?
To answer this question, I examined the whole stock market data for the past 50 years from 1958 to 2007. For each year, I separated stocks into three portfolios: the top 30% P/E portfolio, the middle 40% P/E portfolio and the bottom 30% P/E portfolio. (Stocks with negative earnings are all in the top 30% P/E portfolio.)
If I had invested $1 in each of the three portfolios at the beginning of 1958, by the end of 2007, the top 30% P/E portfolio would have grown to $91; the middle 40% P/E portfolio would have grown to $322 and the bottom 30% P/E portfolio would have grown to $1698! (The chart below shows the growth of $1 in the three different portfolios in logarithmic scale.)
In fact, in the past 5 decades, there was not a single decade in which the bottom 30% P/E portfolio did not outperformed the top 30% P/E portfolio. The decade spanning 1968 to 1977 was especially eventful: two global recessions, the Arab-Israeli war and the Arab oil embargo. The returns of the three portfolios in that decade are as follows:
Top 30% P/E portfolio: 31%
Middle 40% P/E portfolio: 61%
Bottom 30% P/E portfolio: 137%
It is safe to conclude that the P/E ratio is a very useful valuation measure for long-term stock investment. The lower the P/E ratio, the higher is the expected long-term return. That does not mean that low P/E stocks outperform every year though. In the last 50 years, there are 12 years in which the top 30% P/E portfolio outperformed the bottom 30% P/E portfolio. Take 2007 for example, the top 30% P/E portfolio outperformed the bottom 30% portfolio by more than 13%.
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Retirement Investment Bookmarks
Posted on: June 11, 2008
Why is oil closing on $138? James Hamilton has an answer.
William Engdahl argues “60% of today’s oil price is pure speculation“.
J.D. of Get Rich Slowly explains why it pays to ignore financial news.
Newsweek has a piece on the Great Leap Downward of Chines stocks. Did I tell you this last year?
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Over the last 60 years, the simple average annual return of the Fama/French benchmark small-cap portfolio* was 16.3%. For the same period, the large-cap portfolio* was only 12.76%. Do you think small cap beat large cap by a wide margin? I put my mathematician’s hat on to find out.
Volatility shrinks the return difference
The small-cap portfolio return volatility for this period was 26%, and 16.4% for the large cap. Taking into account the drag to return by volatility , I calculated the geometric mean return for both portfolios. My results showed 12.9% for small cap, and 11.4% for large cap. Mathematically, the return advantage of the small-cap portfolio is significantly reduced by its volatility.
The odd favors small cap … somewhat
For most investors, long-term investing means holding a stock for three to five years. What is the odds of the small-cap portfolio beating the large-cap portfolio? Not by much.
In any given three-year period during the last 60 years, the odd of the small-cap portfolio beating the large-cap portfolio were only 51%. It increases to 58% when the investment horizon is 5 years and 72% when the investment horizon is 10 years. For most investors, the odds barely favor small-cap investing.
| Investment horizon | 1 year | 3 years | 5 years | 10 years | 20 years | 30 years |
| Odds of small cap beating large cap | 53% | 51% | 58% | 72% | 75% | 90% |
Data source: Kenneth French data library
Emotional accounting
Daniel Kahneman, the 2002 Economic Nobel laureate and the father of behavioral finance observed that the pain from a loss is twice the pleasure from a gain of the same size.
Applying his principle: I assigned one unit of positive emotion to each 1% gain and deducted two units of positive emotion to each 1% loss. So a resulted positive number represents pleasure and a negative number represents pain. The sum of monthly results over the last 60 years showed: -788 for the small-cap portfolio and -482 for the large-cap portfolio. It is clearly painful to invest in stocks, small cap stocks especially. (This also explains why people prefer to put their money in CDs.) Is the pain of small cap investing worth the gain? You decide.
There are ways to reduce the pain and enhance the gain through diversification and valuations. They are the subjects of my future newsletter, which you can subscribe here.
*Fama/French benchmark small cap portfolio contains stocks in the bottom 30% of market capitalization. Fama/French benchmark large cap portfolio contains stocks in the top 30% of market capitalization.
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Volatility: a drag on return
Posted on: May 16, 2008
In my last article, I explained why volatility does not measure risk. It’s an assertion by none other than Warren Buffet himself. I hope the historical data I used convincingly illustrated the point.
If volatility doesn’t measure risk, then what can we learn from it?
Let’s look at this simple example. Let’s say you invest $100 in asset A, whose volatility is 10%. In year one, the asset returns 10%. In year two, it returns -10%. What is the terminal value in year two? If you’re like most of us mortals, you’d call it a wash. You’d guess $100. Not so, the terminal value is $100*(1+10%)*(1-10%)=$99.
Now let’s assume you invest $100 in asset B, whose volatility is 20%. In year one, the asset returns 20%. In year two, the asset returns -20%. What is the terminal value in year two? This time you should get it right, it is $100*(1+20%)*(1-20*)=$96. So, everything else being equal, we can say higher volatility means lower investment return.
Mathematically speaking, volatility is a drag on return.
Steve Shreve, the math professor in my quantitative finance class, would give you this formula:
Reduction in return = ½ volatility2
For instance, if the annual volatility is 20%, then the drag on annual return is ½*(20%)2=2%. This drag on return is not risk, since it is deterministic – there is nothing uncertain about it.
How to reduce volatility drag on return?
This simple answer is diversification. However, diversification requires special care. Blind diversification could do more harm than good. This is a topic best left for another article.
The author is president of MZ Capital, a RIA serving DC/MD/VA. Get his monthly newsletter in your mailbox.
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Confusing volatility and risk could cost you a bundle. Let’s take a look at returns on an investment of $1000 over 50 years from 1958-2007 in five asset classes.
- Small cap value: $3,750,000
- Small cap growth: $81,200
- Large cap value: $854,000
- Large cap growth: $130,000
- CD: $13,800
Isn’t it obvious which is the best long-term investment?
Why small cap value is the best long-term investment
So you don’t have a 50-year investment horizon? Few of us do. How about a ten-year horizon? In any ten-year period from 1958 to 2007, small cap value had much better investment results than a “safe” CD. (See Table below. Green = best result in the given ten years; red = worst.)
Table: How would $1 investment become?
| 10 year periods | Small Cap Growth | Small Cap Value | Large Cap Growth | Large Cap Value | CD |
| 1958-1967 | $5.64 | $8.02 | $3.22 | $5.39 | $1.36 |
| 1968-1977 | $0.97 | $2.66 | $1.2 | $2.64 | $1.75 |
| 1978-1987 | $3.38 | $7.84 | $3.52 | $4.96 | $2.41 |
| 1988-1997 | $2.87 | $6.47 | $5.38 | $5.13 | $1.7 |
| 1998-2007 | $1.53 | $3.47 | $1.77 | $2.36 | $1.42 |
| Annual volatility | 28.23% | 24.05% | 17.67% | 18.54% | 1.7% |
Safety paradox
Even though a FDIC guaranteed CD is perceived to be safe, over time, inflation eats away at returns. For the long-term investor – and by that we mean you – small cap value is less risky.
Why do few investors put their long-term investment in small cap value? And, when the going gets rough, why do many small-cap-value investors switch their money to CDs?
Here’s why, small cap value is highly volatile (See last row of Table) and volatility makes us anxious and jumbles our judgments.
“Volatility does not measure risk.” -Warren Buffet
Volatility becomes risk only when the investor can’t stand it anymore, and abandons an otherwise safe long-term investment. Typically, volatility is highest and its impact most painful when the market reaches bottom. Not surprisingly, many investors bail out at the worst possible time.
Upon learning that he had to sail by the Sirens – the creatures whose beautiful songs could lure him to jump to his death – Odysseus asked his sailors to tie him to a mast. What mast do you tie yourself to?
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Volatility does not measure risk. The problem is that the people who have written and taught about risk do not know how to measure risk. Beta is nice because it is mathematical, it is easy to calculate and it is wrong – past volatility does not determine the risk of investing. In early 1980s, farmland that had gone for 2,000 an acre, went for $600 an acre. Beta shot up. I was apparently buying a riskier asset at $600 than at $2,000. Real estate not frequently traded. Stocks give you the ability to measure this volatility nonsense.
Because people who teach finance use the mathematics that they have learned, they translate volatility into all types of measures of risks — it’s nonsense. Risk comes from the nature of certain types of business, and from not knowing what you’re doing. If you understand the economics of the business that you’re engaged in and you trust the people you are partnering with, you’re not running significant risk.
Volatility as risk has been very useful for those who teach, never useful for us.
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Retirement investment bookmarks
Posted on: April 17, 2008
Richard Conniff of MSN Money wrote about “How fear can make you lose millions.”
Blind trust in pundits could wipe you out as well. Alice Gomstyn of ABC News asked “Should you stay away from Jim Cramer?” (My answer is yes.)
Bob Klosterman explained life insurance in wealth management.
Greg Mankiw examined Barrack Obama’s tax return, he found Obama is not a fan of retirement saving.
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Investor sentiment is at its lowest since 1990 and second lowest since the American Association of Individual Investors (AAII) sentiment indicator began in 1987. On 2/7/08, the 8-week moving average bull/bear spread reached the low of -25% and has since hovered below -20%. What does it mean for investors that the bull/bear spread stands at -25%? And what is the bull/bear spread?
Are you bullish, bearish, or neutral?
That’s the question asked by the AAII who has been conducting weekly market-outlook surveys of its members since 1987.
The bull/bear spread is the bullish percentage of the answers minus the bearish percentage of the answers. For instance, if 30% are bullish, but 50% are bearish, then the bull/bear spread would be 30%-50%=-20%. Since investor sentiment is very votalile, the 8-week moving averaging is used to smooth out the kinks. The AAII has 20 years of data with which we can study the relationship between investor sentiment and stock market return.
Current low investor sentiment is significant because there were only six instances (excluding this one) when it was below -15%. And only two instances when it was below -20%.
How does bearish investor sentiment relate to stock market return?
I used the small sample of six prior occasions when the bull/bear spread was below -15%. I then studied the subsequent one-year returns by the S&P 500 and the Fama/French Small Cap Value Benchmark Portfolio. The result is displayed in the table below.
| Time (8 weeks ending on ) | 8 week MA bull/bear spread | S&P 500 one year return | Small Cap Value one year return |
| 11/2/1990 | -37% | 25% | 46% |
| 2/7/2008 (this time) | -25% | ?% | ?% |
| 10/23/1992 | -21% | 12% | 40% |
| 3/13/2003 | -18% | 40% | 82% |
| 7/2/1993 | -15% | 0% | 11% |
| 7/20/2006 | -15% | 23% | 23% |
| 3/16/1990 | -15% | 9% | -2% |
| Average | -20% | 18% | 33% |
Data sources: AAII, Kenneth French data library
History shows that the worst decline is over once the indicator shows a reading of -15% or below.
One-year returns for the S&P 500 ranged from 0% to 40%, while those for the Fama/French Small Cap Value Benchmark Portfolio ranged from -2% to 82%. To the extent history repeats itself, the risk rewards of stock investing is heavily skewed toward rewards.
Warren Buffet put it best when he said: “Be greedy when others are fearful.”
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6/22/2007 After Bear Stearns’ hedge funds blew up, Jim Cramer said on CNBC’s Stop Trading:
Buy Bear Stearns! …fund problem won’t spill over.
8/3/2007 According to StreetInsider, Jim Cramer made comments about Bear Stearns, saying he thinks the company shouldn’t have held a conference call to put more bad news into the market …
2/11/2007 Jim Cramer made his Lighting Round bullish calls:
I think you stick with Bear, I think this Justice Department thing will be cleared up.
3/11/2008 Before Bear Stearns’ collapse, Jim Cramer:
Bear Stearns is fine … Bear Stearns is not in trouble. Don’t be silly … Don’t move your money.
3/17/2008 After Bear Stearns’ collapse, Jim Cramer:
I said the common stock was worthless on Friday.
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Best China investment: Taiwan
Posted on: March 10, 2008
Chinese stocks are hot. Taiwanese stocks are not. That’s about to change.
Taiwan will hold its presidential election on March 22nd. Barring an extraordinary electoral surprise, Ying-jeou Ma, the candidate from the pro-business and less China-averse KMT will win the election. (Currently Ying-jeou Ma is leading with 63% in Taiwan’s political futures market.)
The relationship between China and Taiwan is best seen as a broken marriage. China wants to reconcile the rift on its own terms, and threatens consequences if that should not happen. Taiwan, on the other hand, suffers from multiple personality disorder. One part of it wants an outright divorce. The other wants to stay separated with the option of eventual reconciliation.
For the last eight years, Taiwan has been ruled by a president who favored outright divorce. His government has been responsible for hampering economic interactions between China and Taiwan. As the result, Taiwan’s economy languished exactly when China was making a great leap forward. Taiwanese stock market is basically where it was eight years ago. But many emerging economies have seen their stock markets double or even triple during that time. It’s likely we’ll see a catch-up rally once the dust settles after the election.
Even a surprise win by DPP candidate Frank Hsieh wouldn’t be that bad for Taiwanese stocks. He’s seen as a pragmatist within his party. Rhetorically, he would still want the divorce. Economically however, he wouldn’t mind sleeping with China.
Inclusion, if you want a small piece of China in your retirement investment portfolio, you can still have it cheap with a Taiwan ETF (EWT) or some Taiwan ADRs.
Related symbol: EWT
Disclosure: I own EWT
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Jim Cramer:
What I’m saying is that there are bargains right now, there are stocks right now that if you’re shrewd enough, you will be able to buy them at the opening today and you’ll make money in a year from now.
It has been a year since Jim Cramer made his many picks in Mad Money Lighting Round last January. Undoubtedly, many people followed his advice buying his stock picks. To get an idea of how much money they made, I decided to do a little research.
The research is straightforward enough. I looked up the recap of Mad Money Lighting Round at SeekingAlpha.com and tabulated Jim Cramer’s bullish and bearish calls. I then calculated one-year returns from the second (market) day he made the calls.
Bullish: If a bullish call has a one year return higher than that of the S&P 500, it is a right call. If not, it’s a wrong call. Bearish: If a bearish call has a one year return lower than the S&P 500, it is a right call. Otherwise it’s a wrong call.
I calculated the accuracy of his calls by this formula: Accuracy = right call/all calls. I also determined what return a loyal Cramer follower would have made if he/she had bought all of his bullish calls and sold all of his bearish calls.
In January of 2007, Jim Cramer made a total of 194 bullish calls and 123 bearish calls. Out of the 194 bullish calls, 60 are right calls. Out of the 123 bearish calls, 53 are right calls. The accuracy of Jim Cramer’s bullish calls is 30.93% and that of his bearish calls is 43.1%. The combined accuracy is 35.6%.
During the one-year period after Jim Cramer made his calls, the S&P 500 fell an average of 3.72%, his bullish calls on average fell by 3.33% but his bearish calls actually increased by 3.11%.
The table below shows Jim Cramer’s calls on 1/3/2007 and their subsequent one year returns. You may request a complete report of all of his January 2007 calls from MZ Capital.
| Date | Bullish Calls | 1y return | Bearish Calls | 1y return | |
| 1/3/2007 | CVX | 38.46% | XOM | 31.17% | |
| MPEL | -50.53% | MOT | -20.97% | ||
| NYX | -11.22% | NOK | 86.41% | ||
| EBAY | 3.96% | HSY | -20.94% | ||
| SPG | -14.71% | ||||
| NXG | -1.89% | ||||
| AUY | 25.53% | ||||
| KRY | -32.88% | ||||
| DELL | -9.64% | ||||
| WFC | -17.58% |
Data source: SeekingAlpha.com
Research assistance: Ivy Cui
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Retirement investment bookmarks
Posted on: March 2, 2008
Janice Revell of Money Magazine makes a good case that inflation is more of a threat to your retirement than a recession.
Bob Klosterman asks if you are undermining your financial independence by overly risk-averse.
James Hamilton writes scholarly about predicting recession and stagflation.
Talking about inflation, we can’t ignore China’s role. Ebn Esterhuizen has an essay on that.
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Last month, the Fed took a drastic step to cut rate twice by a total of 125 basis points. And with a drop of 225 basis points since last fall, what does this say about likely stock returns? Let’s look at the historical data.
Since 1950, the Fed cut more than 200 basis points 11 times in attempts to simulate a faltering economy. Economists believe it takes six months for the rate cuts to take effect which should last for as long as three years. Therefore I examined the one- and three-year returns of the S&P 500 Index and the Fama/French Small Cap Value benchmark portfolio for each rate-cut period.
After cuts of 200+ basis points, the average one-year return for the S&P 500 was 13.5% with two negative-return periods. The average three-year returns for the S&P 500 was 31.8% with one negative-return period.
However, the Fama/French Small Cap Value benchmark portfolio fared better. The one-year average return is 34.5% with no negative returns. The three-year average return was 100.5% with just one negative-return period.
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Data sources: Federal Reserve, Kenneth French data library
It’s apparent from historical data that Fed rate cuts don’t guarantee making money in stocks. However, they do increase the odds of doing so— particularly with small cap value stocks. (Note: the odds of losing money with the S&P 500 index in any given year is about 30%.)
Martin Zweig once said:
Don’t fight the Fed!
That could be a very wise counsel!
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