Monday, December 12, 2011

The Good Old Days?

By Jim Parker

"The hardest arithmetic for human beings to master," wrote the great American working man's philosopher Eric Hoffer, "is that which enables us to count our blessings."

It's a piece of wisdom worth recalling after another year that has tested the nerve of many investors and prompted questions about what current generations have done to deserve to live in such a tempestuous stage of history.

As the year winds down (if that's the word for it!), financial markets are gripped by uncertainty over developments in the Eurozone crisis. Each day brings fresh headlines that send investors scrambling from virtual despair to tentative optimism.

While not seeking to downplay the very real anxiety generated by these events, particularly in relation to their effects on investment portfolios, it's worth reflecting critically on our often second-hand memories of the "good old days."

A Brief History of the 20th Century

Nearly 100 years ago, Europe was engulfed by a war that destroyed two centuries-old empires, redrew the map of the continent, and left more than 15 million people dead and another 20 million wounded. The economic effects were significant, with widespread rationing in many countries, labor shortages, and massive government borrowing.

Just as the Great War was ending, the world was struck by a deadly pandemic—the Spanish flu, which, by conservative estimates, killed some 50 million people. About a third of the world's population was infected over a two-year period.

A little over a decade after the Great War and the pandemic, the Great Depression cut a swath through the global economy. Industrial production collapsed, international trade broke down, unemployment tripled or quadrupled in some cases, and deflation made already groaning debt burdens even larger.

In the meantime, resentment was growing in Germany over its Great War reparations to the Allied powers. Berlin resorted to printing money to pay its debts, which in turn led to hyperinflation. At one point, one US dollar converted to 4 trillion marks.

In a new militaristic and nationalist climate, fascist regimes arose in Germany, Italy, and Spain. Under Hitler, Germany defied international treaties and began annexing surrounding regions in Austria and Czechoslovakia before finally attacking Poland in 1939.

This led to the Second World War, a conflict that engulfed almost the entire globe while Japan pushed its imperial ambitions in Asia, and Germany sought to conquer Europe. More than 50 million died in the ensuing conflict, including a holocaust of six million Jews. The war ended with the invasion of Berlin by Russian and western forces, while Japan surrendered only after the US dropped nuclear bombs on two cities, killing a quarter of a million civilians.

In economic terms, the war's impact was profound. Most of Europe's infrastructure was destroyed, millions of people were left homeless, much of the UK's urban areas were devastated, labor shortages were rife, and rationing was prevalent.

While the thirty-five years after World War II were seen as a golden age in comparison, the geopolitical situation remained fraught as the nuclear armed superpowers, the Soviet Union and the US, eyed each other. The breakdown of the old European empires and growing east-west tensions led the US and its allies into wars in Korea and Vietnam.

The cost of the Vietnam and cold wars created enormous pressures concerning balance of payments and inflation for the US and led in 1971 to the end of the post-WWII Bretton Woods system of international monetary management. The US dollar came off the gold standard, and the world gradually moved to a system of floating exchange rates.

In the mid-1970s, the depreciation of the value of the US dollar and the breakdown of the monetary system combined with war in the Middle East to encourage major oil producers to quadruple oil prices. Stock markets collapsed and stagflation—a combination of rising inflation alongside rising unemployment—gripped many countries.

While the 1980s and 1990s were a relative oasis of calm—aided by the end of the cold war—there still was no shortage of bad news, including the Balkan wars, the Rwandan genocide, and recessions in the early part of both decades.

In the past decade, there have been the tragedies of 9/11; the 2004 Asian tsunami; the 2011 Japanese earthquake, tsunami, and nuclear crisis; and now, the financial crisis sparked by irresponsible lending, complex derivatives, and excessive leverage.

Another Perspective

So from this potted history, it seems fairly clear that tragedy and uncertainty will always be with us. But the important point to take away from it is that previous generations have stared down and overcome far greater obstacles than we face today. And while it is easy to focus on the bad news, we mustn't overlook the good either.

Alongside the wars, depressions, and natural disasters of the past century, there were some notable achievements for humanity—like women's suffrage, the development of antibiotics, civil rights, economic liberalization, the spread of prosperity and democracy, space travel, advances in our understanding of the natural world, and enormous advances in telecommunication. (Oh, and the Beatles.)

Today, while the US and Europe are gripped by tough economic times, much of the developing world is thriving. Populous nations such as China and India are emerging as prosperous nations with large middle classes. And smaller, poorer economies are making advances too.

The United Nations in the year 2000 adopted a Millennium Declaration that set specific targets for ending extreme poverty, reducing child mortality, and raising education and environmental standards by 2015. In East Asia, the majority of twenty-one targets have already been met or are expected to be met by the deadline. In Africa, about half the targets are on track, including those for poverty and hunger.

Alongside these gains, new communications technology is improving our understanding of different cultures and increasing tolerance across borders while providing new avenues for the spread of ideas in education, health care, technology, and business.

Through forums such as the G20 and APEC, international cooperation is increasing in the field of trade, addressing climate change, and lifting the ability of the developing world to more fully participate in the global economy.

Rising levels of education and health, and workforce participation also mean the foundations are being built for a healthier and peaceful global economy, dependent not on debt, fancy derivatives, and fast profits but on sustainable, long-term wealth building.

Anxiety over recent market developments is completely understandable, and it is quite human to feel concerned about events in Europe. But amid all the bad news, it is also clear that the world is changing in positive ways that provide plenty of cause for hope and, at the very least, gratitude for what we already have. These are ideas to keep in mind when we scan the news and long for the "good old days."

Monday, December 5, 2011

What Does a Winning Streak Tell Us

By Weston Wellington

Bill Miller is one of the most closely watched money managers in the industry, so it was big news when he announced his decision last week to step down as portfolio manager of Legg Mason Capital Management Value Trust (LMVTX) early next year. His departure also adds an intriguing chapter to the long-running debate regarding the value of active stock selection.

Miller's most frequently cited accomplishment is the fifteen-year period from 1991 through 2005, during which Value Trust outperformed the S&P 500 each calendar year, the only US equity fund manager to have ever done so. His success attracted a wide and enthusiastic following: Morningstar named him Portfolio Manager of the Decade in 1999, Barron's included him in its All-Century Investment Team that same year, and a Fortune profile in 2006 described him as "one of the greatest investors of our time." A former US Army intelligence officer and philosophy student, his formidable intellect covered a wide range of interests, and he believed that conventional investment analysis could be enhanced with insights drawn from literature, logic, biology, neurology, physics, and other fields not obviously related to finance. His expressed desire to "think about thinking" suggested an unusual ability to assess information differently from other market participants and arrive at a more profitable conclusion.

Miller's bold and concentrated investment style would never be confused with a "closet index" approach. Big bets on Fannie Mae, Dell, and America Online, for example, were rewarded with handsome gains (as much as fifty times original cost in the case of Fannie Mae). Unfortunately, similar bets in recent years revealed the dangers of a concentrated strategy as heavy losses in stocks such as Bear Stearns and Eastman Kodak penalized results. For the five-year period ending December 31, 2010, LMVTX finished last among 1,187 US large cap equity funds tracked by Morningstar. Considering the enormous variation in outcomes among these carefully researched ideas, Miller's overall investment record presents an interesting puzzle: How can we disentangle the contribution of good luck or bad luck, of skill or lack of skill?

Over the May 1982–October 2011 period, annualized return was 11.28% for the S&P 500 Index and 11.76% for the Russell 1000 Value Index. Value Trust slightly outperformed the S&P and underperformed the Russell index by over 0.40% per year. A three-factor regression analysis over the same period shows the fund underperformed its benchmark by 0.08% per month.

Do these results offer conclusive evidence of the failure of active management? Not necessarily. The fund's expenses are above average at over 1.75% and provide a stiff headwind for any stock picker to overcome. Gross of fees, the fund's performance over and above its benchmark goes from –0.08% to 0.07% per month. This swing from negative to positive raises an interesting point that Ken French speaks to at every Dimensional conference. There are almost certainly some mistakes in market prices and almost certainly some skillful managers who can exploit them. But who is likely to get the benefit of this knowledge—the investor with his capital or the clever money manager? If stock-picking talent is the scarce resource, economic theory suggests the lion's share of benefits will accrue to the provider of the scarce resource—just what we see in this instance.

To cloud the discussion even further, both of these results, positive and negative, flunk the test for statistical significance; in neither case can they be attributed to anything more than chance. So even with twenty-nine years of data, we cannot find conclusive evidence of manager skill—or lack thereof. This is the inconvenient truth that every investor must confront: The time required to distinguish luck from skill is usually measured in decades, and often far exceeds the span of an entire investment career.

Miller is well aware of the challenge of distinguishing luck from skill and has conspicuously declined to boast about his results, even when they were unusually fruitful. He has acknowledged that topping the S&P 500 each year for fifteen years was an accident of the calendar and that using other twelve-month periods produced a less headline-worthy result.

Commentators have said that Miller has "lost his touch" or that his investment style is no longer suitable in the current market environment. These arguments strike us as the last refuge for those who find the idea of market equilibrium so unpalatable that they search for any explanation of his change in fortune other than the most plausible one—prices are fair enough that even the smartest students of the market cannot consistently identify mispriced securities.

Where does this leave investors seeking the best strategy to grow their savings?

When asked by a New York Times reporter in 1999 to sum up his legacy, Miller replied, "As William James would say, we can't really draw any final conclusions about anything." Twelve years later, this observation seems more useful than ever. And investors would be wise to treat even the most impressive claims of financial success with a healthy degree of skepticism.


Andy Serwer, "Will the Streak Be Unbroken," Fortune, November 27, 2006.

Edward Wyatt, "To Beat the Market, Hire a Philosopher," New York Times, January 10, 1999.

Tom Sullivan, "It's Miller Time," Barron's, October 12, 2009.

Diana B. Henriques, "Legg Mason Luminary Shifts Role," New York Times, November 18, 2011.

S&P data provided by Standard & Poor's Index Services Group.

Morningstar data provided by Morningstar Inc.

Russell data copyright 2011, Russell Investment Group 1995-2011, all rights reserved.

Saturday, December 3, 2011

Bards of the Bar

By Jim Parker

As a topic of conversation, investment is like sports. Everyone has an opinion. And the strongest opinions often come from those who spend more time in front of the TV than out on the field. Practitioners, meanwhile, are wary of anything labeled a sure thing. Indeed, it's one of life's ironies that the people who know the least about a subject sound the most sure of themselves. In investment, these are the ones who prop up bars telling anyone who will listen that they have found the path to certain wealth.

These pub philosophers tend either to be permanent bulls or permanent bears about the market. They have their standard story, and they adapt the facts to fit. Some of them even end up writing newspaper columns and hosting television shows.

By contrast, some of the world's most respected and seasoned investors strike a humbler tone, having learned from personal experience about the unpredictability of markets and deciding to focus instead on those things within their control.

Take, for instance, the frequently heard line that smart investors should seek to time their entry points to markets and wait for the volatility to clear. We are hearing a lot of that right now as the European crisis dominates market attention.

Writing about this in 1979 before one of the biggest bull markets in history, Warren Buffett said: "Before reaching for that crutch (market timing), face up to two unpleasant facts: The future is never clear [and] you pay a very high price for a cheery consensus. Uncertainty actually is the friend of the buyer of long-term values."1

Another line from the pub philosophers is that the job of an investment expert is to spot the best market-beating returns and harvest them before someone else finds out.

Asked about this in 2007, two years before his death, legendary investment consultant and historian Peter Bernstein said it was better to focus on risk than return. "The central role of risk, if anything, has grown rather than diminished," he said. "We really can't manage returns because we don't know what they're going to be. The only way we can play the game is to decide what kinds of risk we're going to take."2

A third perennial pub conversation is the role of stock picking in investment success. The line here is that the key to wealth building lies in painstakingly analyzing individual stocks and buying them based on a forecast or even a hunch about their prospects.

Prompted by a newspaper reporter for his opinion on that piece of conventional wisdom, Charley Ellis, long-time Wall Street observer and the founder of Greenwich Associates, said the truth was actually quite the opposite.3

"The best way to achieve long-term success is not in stock picking and not in market timing and not even in changing portfolio strategy," Ellis said.

"Sure, these approaches all have their current heroes and war stores, but few hero investors last for long and not all the war stories are entirely true. The great pathway to long-term success comes via sound, sustained investment policy, setting the right asset mix and holding onto it."

While that's probably not the kind of message you are likely to hear from the instant experts who prop up your local bar, it may be a more durable and a more useful one.

Monday, November 28, 2011

The Paradox of Skill

By Brad Steiman

Statistical significance is extremely important when drawing conclusions from noisy data. Noise in the data is problematic when investors overemphasize what might have been a period-specific outcome rather than a robust and repeatable result that is likely to persist going forward. Manager selection is a process that requires analyzing noisy performance data, so it should lean heavily on the notion of statistical significance.

When advisors, consultants, or investors select a manager, their approach often involves a combination of qualitative and quantitative analysis. The latter, by necessity, requires the use of past performance, as it is essentially all we have to evaluate. The focus is typically on managers with a positive "alpha" (i.e., outperformance relative to a benchmark or asset pricing model). Although past performance represents what actually happened, new investors cannot get those returns; therefore, the objective of the analysis is to determine whether outperformance in the past is any indication of skill, or simply good luck. In other words, is the positive alpha likely to persist in the future, after the manager is selected?

This task is more difficult than many investors might think. Several notable studies of manager performance found little persistence in past performance.1 Regardless, investors rarely hire managers with a history of poor relative performance, so the manager selection merry-go-round often becomes:

  1. Hire managers who have outperformed in the past.
  2. Fire managers who underperform in the future.
  3. Repeat.

This activity meets Einstein's definition of insanity, as many investors do the same thing over and over again while expecting different results. There are many reasons why this is an exercise in futility:

  • It generally takes a long track record for a manager's alpha to be statistically significant.
  • Positive alphas, even statistically significant ones, may not be an indication of skill.
  • By the time you are confident there is skill, it's probably too late to benefit.
  • Past performance is (really) no indication of future performance.
  • If you know for sure the manager has skill, you likely won't benefit because the scarce resource captures the rent!

It Takes Time

Finding managers with positive alphas is like looking up the box scores from last night's games, but picking those who will outperform in the future is anything but trivial. To begin with, a quantitative analysis of past performance should incorporate tests of statistical significance to determine the likelihood their true alpha is not zero. In most cases, a long track record is required for the manager's alpha to be statistically significant. Given the average alpha and the standard deviation of the alpha, we can determine the track record required (in years) to obtain a t-stat of 2.

Table 1. Minimum track record for a statistically significant alpha (t-stat > 2)

Average Alpha

of Alpha

A track record of outperforming a benchmark or asset pricing model by an average of 2% per year (net of fees) over the life of the fund would get the attention of many investors, especially when you consider that the equity premium might only be around 5%. A representative standard deviation of alpha in the Morningstar universe of actively managed US equity mutual funds is approximately 6%.2 As illustrated in the table above, a 2% average alpha and a 6% standard deviation of the alpha requires a track record of thirty-six years before you can be 95% sure that the true alpha is not in fact zero (i.e., there was no skill at all). Based on these parameters, by the time you are reasonably confident there is some amount of skill, the manager is likely retired and on her yacht!

The Effects of Chance

Identifying a skillful manager involves more than simply narrowing down the universe to funds with positive alphas and a t-stat of 2 or more. This approach ignores the effects of chance. There is still a 2.5% probability the outperformance was due to good luck, and the true alpha of the manager is zero. Said another way, one out of forty managers is expected to have a positive alpha with a t-stat of 2 by chance. With so many funds in the universe, many will have statistically significant alphas even when there is no skill at all.

For example, in a 5,000-fund universe, 125 managers are expected to have a positive alpha with a t-stat greater than 2, even if their true alpha is zero. Unfortunately for investors, the opportunity is not in sorting through the many managers with statistically significant alphas, but rather in finding these managers because there are too few of them. Fama and French recently studied 3,156 US equity funds and compared their performance to a simulated universe of funds in which the true alpha for every fund was zero. Their results identified fewer funds with statistically significant alphas than you would expect to find by chance.3

By Then, It's Too Late

An investor concluding that a statistically significant alpha is evidence of skill could be guilty of data mining, meaning he is making inferences from what might have been a chance outcome limited to that time period. To counter these claims, academics conduct out-of-sample tests to confirm a statistically significant result. For example, out-of-sample data can be obtained by repeating the experiment using an independent time period (e.g., 1926–1962 rather than 1963–1992) or a different data set from an overlapping time period (e.g., international rather than US market data).

Practitioners should also conduct out-of-sample tests when analyzing manager performance to help rule out that a statistically significant alpha didn't occur by chance. On the surface, conducting out-of-sample tests might seem like an overly cautious approach akin to wearing a belt and suspenders. However, even if this were true, when you consider the consequences and what is at stake, it sure beats getting caught with your pants down.

The only way to test out-of-sample data when doing performance analysis is by using totally independent time periods. Accordingly, the number of years required in Table 1 gets multiplied by the number of independent periods you're comfortable with before you have faith there is some amount of robust and repeatable skill.

Table 2. Minimum track record for two independent periods with statistically significant alpha (t-stat > 2)*

Average Alpha

of Alpha

* Assumes the average alpha and standard deviation is the same in both time periods.

Using the prior example of a 2% average alpha and a 6% standard deviation of the alpha means you need a track record of seventy-two years if you're satisfied with a statistically significant result from only two independent time periods. But, in this instance, by the time you think there is evidence of skill, it's too late—the manager may be dead!


Having said that, let's assume you've found a manager with statistically significant alpha in multiple independent periods and she is not yet retired or deceased. The question still remains: will the positive alpha continue? You cannot rule out luck because of the effects of chance noted above, but more important, many performance studies conclude that winners do not continue to win, and even when there is alpha in the extremes, it does not persist. The only slight indication of persistence is among the extreme losers, and it is mostly explained by high fees and high turnover.4

If we eliminate these funds from consideration, manager selection becomes a random draw, but whether investors know they are picking them at random is another question. Their goal is often to achieve top quartile performance, and pursuit of this goal usually boils down to choosing from managers among the top quartile in the past. However, excluding the persistent losers noted above, yesterday's top quartile performers have the same 25% probability of being in tomorrow's top quartile as every other manager!

Scarce Resources

Ironically, the predicament is not only for the investor trying to identify skill but for managers trying to prove they have it. A fundamental of economics is that the scarce resource captures the rent. If capital is freely floating and perfectly liquid, then the scarce resource is not the investor's money but the manager's skill! There is an enormous economic incentive for managers to indisputably prove they are in possession of this elusive ability.

Let's assume a manager has a twenty-year track record of outperforming by 4% each year. In this extreme example, a t-stat is meaningless since the standard deviation of the alpha is zero. If we rule out the possibility of a Ponzi scheme, the manager surely has undeniable skill. However, as soon as she proves her unique ability, she can capture the rent by increasing her fees to nearly 4%. An increase in fees of this magnitude may draw the ire of her investors, so, alternatively, she could raise more and more assets, thereby distributing her alpha over a larger asset base, which would dilute investor results.5 This latter approach may largely go unnoticed by investors, but either way they lose as their alpha subsequently becomes zero.

Making Progress

So, herein lies the paradox of skill. Many investors are searching for the Holy Grail of fund management. Their goal is to identify a skillful manager with certainty and participate in future returns. But confirming skill takes an investment lifetime, and you can never be fully confident that the alpha is not random. Even if you could identify skill ahead of time, you probably would not benefit. Winning managers hike their fees or attract large volumes of new investment long before their skill is statistically confirmed—and both actions can dilute returns.

But this paradox is not a case of "damned if you do and damned if you don't" for all investors. You can get off the manager selection merry-go-round and start making progress toward a successful investment experience by following these simple principles:

  1. Diversify by asset class rather than by fund manager, broker, or advisor.
  2. Buy into markets, not managers, and let capitalism be your guru.
  3. Focus on what you can control—costs, asset allocation, risks, and discipline. Ignore what you cannot control—the media, prognosticators, market returns, and your gut.
  4. Work with an advisor who understands these principles and can help you apply them.

The comments of Weston Wellington are gratefully acknowledged.

1. Noteworthy studies include: Mark Carhardt, "On Persistence in Mutual Fund Performance," Journal of Finance 52, no. 1( March 1997). Garrett Quigley and Rex A. Sinquefield, "Performance of UK Equity Unit Trusts," Journal of Asset Management 1, 72-92. James L. Davis, "Mutual Fund Performance and Manager Style," Financial Analysts Journal 57, no. 1 (Jan/Feb 2001).

2. Source: Index Funds Advisors.

3. Eugene F. Fama and Kenneth R. French, "Luck Versus Skill in the Cross Section of Mutual Fund Returns," Journal of Finance 65, no. 5 (October 2010): 1965–1947.

4. Carhardt, "On Persistence in Mutual Fund Performance." Fama and French, "Luck Versus Skill in the Cross Section of Mutual Fund Returns."

5. Jonathan Berk and Richard C. Green, "Mutual Fund Flows and Performance in Rational Markets," NBER Working Paper No. W9275, October 2002.

Wednesday, November 16, 2011

Don't Worry Over Largest Ever Muni Bond Default

By Larry Swedroe


Alabama's most populous county declared bankruptcy in hopes of addressing a massive revenue shortfall and its whopping $4.15 billion in debt. Jefferson County's Chapter 9 filing is the largest municipal bankruptcy in U.S. history.

This formal declaration doesn't necessarily mean investors will lose their money. Consider the 1994 case of Orange County, Calif., which was the largest municipal bankruptcy on record prior to Jefferson County, with debts totaling $1.7 billion. In the end, all debts were fully repaid.

Jefferson County's declaration provides us with a good opportunity to review the overall state of the municipal bond market. Last December, Meredith Whitney caused quite a stir when she predicted on CBS' "60 Minutes" "between 50 and 100 'significant' municipal bond defaults in 2011, totaling 'hundreds of billions' of dollars." Her forecast helped trigger investors to withdraw money from municipal bond funds for 24 consecutive weeks. Unfortunately for Whitney and those investors who gave credence to her forecasts, it would be hard for her to have been more off the mark.

Meredith Whitney on 60 Minutes

The massive scale of problems that Whitney anticipated hasn't appeared because governments have taken actions to address the problem -- cutting spending and raising revenues. Unlike the federal government, states are required to balance their budgets. As a result, budget gaps are being closed by layoffs of public employees, greatly reduced services, renegotiation of contracts with union members on wages and especially benefits, and increased taxes and fees. These actions have gotten results. For example:

-- Preliminary data from the Rockefeller Institute reported that state revenues from July and August were 6.8 percent higher than the same period in 2010.

--Standard and Poor's said municipal bond defaults were down 69.0 percent from January through October, versus the same period in 2010.

--Prior to Jefferson county's declaration, outstanding defaulted issues totaled just $6.6 billion.

It's also important to point out that of the now 200 outstanding defaulted issues, 8.0 percent were issued for multifamily residential projects, 10.5 percent for health care, and 43.7 percent for land-backed deals. These are sectors of the municipal bond market I recommend you don't even consider (regardless of the credit rating) because of their relatively poor historical default records.

While the year isn't quite over, the roughly $11 billion in defaults is a long way from hundreds of billions. Keep these results in mind the next time you're tempted to react to some dire forecast. And remember that the academic research on the ability to forecast the future demonstrates that it's not possible. The only good predictor is fame -- the more famous the forecaster, the more likely he or she is to be wrong.;lst;3

October Fest

By Jim Parker

Ever noticed how gamblers always tell you about their big wins, but tend to keep their even bigger losses close to their chests? People who seek to finesse their entry and exit of financial markets are similar.

Going awfully quiet in recent days have been the analysts who a month ago were saying that that was the time to get out of risk assets. It seemed a good call at the time as global stock markets had suffered their worst quarter in nearly three years.

Pummelling confidence were a host of concerns, including the European sovereign debt crisis, signs that global growth was stalling and a general lack of confidence in policymakers to take effective action to avoid another recession.

One chartist quoted by Dow Jones1 said the US market was breaking down in what could be a very nasty prelude to the fourth quarter. The advice from the technical analysts was that investors needed to be extremely wary buying stocks in October.

Adding to the nerves were the now routine reminders2 to investors about October supposedly being the "scariest" month for shares, with two of the biggest crashes in history occurring in the 10th month of the year–in 1929 and 1987.

Now while further volatility may well still lay ahead, those who took that advice and bailed out of risky assets at the end of September might now be ruing their decision.

The US S&P-500 rose by nearly 11 per cent in October, its largest monthly rise since 1991.3 That was the year that dance act 'C&C Music Factory' was topping the pop charts and 'The Silence of the Lambs' won Best Picture at the Academy Awards.

But it wasn't just a US story. The MSCI All-Country World Index rose by 10 per cent in October in US dollar terms, its largest one-month rally since April, 2009. In Australia, the S&P/ASX-200 gained 7.2 per cent in local currency terms, its best one-month performance since July, 2009. What's more, among the biggest gaining sectors in October were financials, energy and materials sectors, which had all lagged in the defensive mood of the prior months.

These are significant upward movements and will have eased some pain for investors after five-to-six months of consecutive decline in equity markets, but not if you had listened to the advice of some of the Jeremiahs in the financial media.

It's not often appreciated by ordinary investors that markets are forward looking. We know the news has been bad, but it's what comes next that counts. Selling out after a bad run in the markets just means you turn paper losses into real ones and leave yourself with the extremely difficult challenge of finessing your re-entry point. The reversal of direction in October highlights this difficulty.

We don't know if these October gains are sustainable — and already in November, sentiment around Europe has turned sour again. But we do know that markets can move quickly and respond to new information instantaneously. That's why market timing is so hard and why the best approach is to maintain your chosen asset allocation–with periodic rebalancing–irrespective of the week-to-week and month-to-month noise.

1.'MARKET TALK: Use Extreme Caution Buying Stocks' — Dow Jones Newswires, Sept 24, 2011

2.'Share Jitters Deny US Rise', Daily Telegraph, Sydney, Sept 26, 2011

3.'US Stocks Decline Amid Concern About European Funding', Bloomberg, Oct 31, 2011

Thursday, November 3, 2011

Increased Market Volatility: Fact or Fiction?

By Larry Swedroe

The financial media has been filled with headlines about market volatility. From one perspective, this may make sense, as the previous quarter saw 19 trading days experience market moves of more than 2 percent, compared with just one such day the previous quarter.

Based on my conversations with both investors and advisors alike, the perception is that markets have certainly become more volatile. The question is: “Does the historical evidence match up as well?” To find the answer, we go to our trusty videotape.

For the period 1927-1999, the annual standard deviation (measure of volatility) of the S&P 500 Index was 20.3 percent. From 2000 through 2010, the annual standard deviation was a virtually identical 20.5 percent.

Perhaps if we look at the data on a quarterly basis, we’ll find more volatility. The quarterly standard deviation of the S&P 500 prior to 2000 was 11.7 percent. Since then, it has been 9.0 percent — volatility prior to 2000 was 30 percent higher.

So let’s try looking at the data on a monthly basis. Prior to 2000, the monthly standard deviation was 5.7 percent. Since then it has been just 4.7 percent — volatility prior to 2000 was more than 20 percent higher.

Small-Cap Stocks
Since we can’t find the explanation in the large-cap stocks of the S&P 500, perhaps we can find it in small-cap stocks. From 1926 through 1999, the annual standard deviation of the CRSP 6-10 Index (which represents small-cap stocks) was 31.2 percent. For the period 2000 through 2010, the annual standard deviation was 28.7 percent. The annual volatility of small caps was 9 percent more prior to 2000 than it was after. On a quarterly basis, the standard deviation was 19.7 percent prior to 2000 and just 12.9 percent from 2000 through June 2011. Prior to 2000, the quarterly volatility was 53 percent higher. On monthly basis the standard deviation prior to 2000 was 8.1 percent. Since then it was 6.7 percent. Prior to 2000 the monthly volatility was more than 20 higher than it has been since.

International Markets
Perhaps if we look at the volatility of international markets, we’ll find the explanation for the perception that the equity markets have been more volatile. From 1970-99, the annual standard deviation of the MSCI EAFE Index was 20.6 percent. From 2000 through 2010, the annualized standard deviation has been a virtually identical 20.7 percent. So that probably isn’t the source of the perception either, though we note that the monthly and quarterly volatility of the MSCI EAFE was 8 percent and 17 percent higher, respectively, since 2000.

Emerging Markets
Stretching the case, we can also look at emerging markets. Here we do find a relatively small increase in volatility, not the much greater increase the media and the “experts” have portrayed. On annual basis, the standard deviation of returns was 36.7 percent from 1988 through 1999, and 38.3 percent from 2000 through 2010, an increase of just 4 percent. On quarterly basis (through September 2011), the standard deviation increased from 13.6 percent to 14.1 percent, an increase of 4 percent. On monthly basis, the standard deviation increased from 6.9 percent to 7.1 percent, an increase of just 3 percent. These small increases almost assuredly wouldn’t have been noticed by most investors, and thus can’t explain why there’s this perception of greatly increased volatility.

Since I don’t have access to the daily data, I can’t rule the possibility that the perception of higher volatility is caused by the markets being more volatile on a daily basis. But investing for the long run while paying attention to the market’s daily noise is (as Alan Abelson noted) like a man walking up a big hill with a yo-yo and keeping his eyes fixed on the yo-yo instead of the hill. The bottom line is that the media needs to create noise to get you to pay attention, even if paying attention is bad for both your stomach and your investment results.

Photo courtesy of Katrina.Tuliao on Flickr.

Wednesday, October 26, 2011

What's in Your View Finder?

By Weston Wellington

He is no longer with us, and the world is poorer for it.

A restless college dropout, he founded a wildly successful company whose innovative products touched millions of lives. He was a brilliant, dictatorial, and cantankerous leader, relentlessly pushing his staff to solve one impossible problem after another. He had no use for conventional market research, and trusted his own vision to create products with little detectable demand that flew off the shelves upon introduction. He zealously guarded his personal privacy but reveled in his role as a master magician on stage when introducing his firm's latest innovations to eager crowds of industry followers. Stockholders wore big smiles as the shares vaulted to one new high after another. In many ways, he was the antithesis of the conventional corporate chieftain, and despite his demanding persona, he was revered by employees, customers, and even competitors to a greater extent than almost any other chief executive in recent memory.

A tribute to the late Steve Jobs? No—to Edwin Land of Polaroid.

The son of a scrap metal dealer, Land dropped out of Harvard to pursue his own research at the New York Public Library on polarized light filters. He founded Land-Wheelwright Laboratories in 1934 with his former physics professor, and his low-cost polarizing filters proved useful in products ranging from sunglasses to army tank telescopes and gunsights. After the war, he turned his attention to photography and introduced the Polaroid-Land instant camera in 1948. Despite a stiff price tag of $89.75 the first shipment of 57 cameras sold out in a matter of hours at a Boston department store, and the firm never looked back.

Numerous improvements followed, and sales boomed as the cameras and film became smaller, lighter, easier to use, and less expensive. The stock price did likewise, and Polaroid became a bellwether "glamour" stock during the postwar bull market, soaring tenfold in just five years from 1963 to 1967.

When a cover story in Time appeared in June 1972, Polaroid seemed all but unstoppable. Land's inventive genius had resulted in an astonishing new industry with technology protected by a wall of over 1,000 patents. (Land himself held 535 patents, second only to Thomas Edison.) Eastman Kodak offered only token competition in instant photography, and was eventually vanquished in both the marketplace and the courtroom. Kodak was forced to pay Polaroid nearly $1 billion to settle a patent infringement suit and withdrew from the instant camera business. Polaroid shares reached an all-time high of $149.50 in mid-1972, amid intense excitement over the ingenious new SX-70 single lens reflex color camera and rumors of an instant movie product. Government surveys at the time identified photography as one of the fastest-growing industries in the country, and Polaroid appeared to be a key beneficiary: In the premium category (cameras selling for $50 or more), Polaroid was not only the undisputed leader but outsold all other global competitors combined.

Land was one of Steve Jobs' heroes, and the youthful computer tinkerer from California felt almost a mystical connection with the Cambridge scientist forty-six years his senior. Both were impatient perfectionists, often driving themselves even harder than their overworked employees. Land was infamous for wearing out staff members, who rotated in shifts while he focused on knotty problems. During one marathon research session, Land wore the same clothes for eighteen straight days. When Jobs had the opportunity to meet Land personally, he found that he and Land shared a peculiar characteristic: Both believed that new products were not invented so much as discovered. Both could visualize a product that did not yet exist down to its smallest details, and the task of development was thus akin to Michelangelo's description of sculpture: The artist's task was to remove the unnecessary material to reveal the beauty already contained within the stone.

Alas, Time's cover story marked the beginning of the end. The instant movie project ("Polavision") turned out to be a costly failure and led to Land's resignation in 1980. Jobs was dismayed when Land was pressured to leave the firm he had founded, calling him a "national treasure." Jobs would suffer a similar fate after a losing boardroom battle in 1985.

Although Polaroid products continued to sell well, the shift to digital photography caught the firm unprepared and slowly hollowed out the highly profitable film business. Polaroid filed for bankruptcy in October 2001. The research labs and film factories were shuttered, although the brand name, traded from one sharp-elbowed financier to another, survives as a ghostly reminder of its illustrious past. The years have been kinder to Eastman Kodak, but not by much. Founded long before Polaroid in 1888, it has outlived its former adversary but now struggles to avoid a similar fate.

What is the message for investors?

As we observed in a previous note, the forces of competition are relentless, and today's astonishing innovation may be tomorrow's commodity—or garage sale castoff. We have no reason to believe that Apple has anything but a bright future, but those of us tempted to concentrate our investment capital in a handful of exciting industry leaders should consider the fate of Polaroid before declaring, "It can't happen here."

Securities Research Company, SRC Green Book, 1993 edition.

"Polaroid's Big Gamble on Small Cameras," Time, June 26, 1972.

"The Story of Polaroid Inventor Edwin Land, One of Steve Jobs' Biggest Heroes," 37signals, accessed October 14, 2011.

Tuesday, October 4, 2011

The Accuracy of Experts' Forecasts

By Larry Swedroe

There’s an overwhelming body of evidence on the inability of forecasters to make accurate predictions. This inability is one reason why efforts to outperform the market without taking more risk have failed with such persistence. This is true for both the stock and bond markets. The following is a recent example that while it might be easy to make a living selling forecasts, it’s very difficult for even the experts to make accurate forecasts.

A year ago, the Reuters news agency polled 16 money market dealers who do business directly with the Federal Reserve. These “primary dealers” — banks or broker-dealers — are market makers for government securities. They even consult directly with the US central bank and Treasury about funding the budget deficit and implementing monetary policy.

One might hypothesize that if anyone could get the forecast right it would be them. Reuters asked the dealers for their forecasts for Treasury bond yields three, six and 12 months ahead. Their consensus forecast was for 10-year Treasury note yields to rise from 2.5 percent to 3.2 percent by September 2011. Investors paying attention would shorten maturity risk. Today, we know that they were not only off by about 1.5 percent (the 10-year note now yields about 1.75 percent), but more importantly from a strategy standpoint, they got the direction wrong. Investors who paid attention not only failed to earn the term premium that existed at the time, and missed out on the large capital gains that the fall in rates produced, but now they’re faced with reinvesting at much lower interest rates.

But they weren’t the only ones that got it dead wrong. In February 2011, the bond “king” Bill Gross announced that the world’s biggest bond fund had reduced its US government-related debt holdings from 22 percent in December 2010 to just 12 percent in January 2011, the lowest in two years. In March, PIMCO announced it had eliminated government related debt entirely from its flagship fund, saying that bond yields had reached unsustainably low levels given the scale of government debt obligations and the chance of a correction when the Fed ended its quantitative easing program.

By August, Gross admitted he had made a big mistake, and he reversed course.

The aforementioned failures of the so-called experts to get forecasts right is nothing new. William Sherden, author of The Fortune Sellers, was inspired by the following incident to write his book. In 1985, when preparing testimony as an expert witness, he analyzed the track records of inflation projections by different forecasting methods. He then compared those forecasts to what is called the “naive” forecast — simply projecting today’s inflation rate into the future. He was surprised to learn that the simple naive forecast proved to be the most accurate, beating the forecasts of the most prestigious economic forecasting firms equipped with PhDs from leading universities and thousand-equation computer models.

Sherden reviewed the leading research on forecasting accuracy from 1979 to 1995 and covering forecasts made from 1970 to 1995. He concluded that:

  • Economists cannot predict the turning points in the economy. He found that of the 48 predictions made by economists, 46 missed the turning points.
  • Economists’ forecasting skill is about as good as guessing. Even the economists who directly or indirectly run the economy (such as the Fed, the Council of Economic Advisors and the Congressional Budget Office) had forecasting records that were worse than pure chance.
  • There are no economic forecasters who consistently lead the pack in forecasting accuracy.
  • There are no economic ideologies that produce superior forecasts.
  • Increased sophistication provided no improvement in forecasting accuracy.
  • Consensus forecasts don’t improve accuracy.
  • Forecasts may be affected by psychological bias. Some economists are perpetually optimistic and others perpetually pessimistic.

Economist and Nobel Laureate Paul Samuelson observed: “I don’t believe we’re converging on ever-improving forecasting accuracy. It’s almost as if there is a Heisenberg [uncertainty] Principle.” Michael Evans, founder of Chase Econometrics (now IHS Global Insights), confessed: “The problem with macro [economic] forecasting is that no one can do it.”

The bad news is that no matter how much we want to believe in fortune tellers, the problem is that they all have cloudy crystal balls. One reason for the inability of even the experts to see through those clouds is that markets have a nasty tendency to provide surprises, which by definition are not forecastable. The result is that the efforts to try and manage returns are highly likely to prove unproductive. Instead, you should focus on the things you actually can control, the types and amount of risk you take, diversifying those risks prudently, costs and tax efficiency.

And finally, remember that since the underlying basis of most stock market forecasts is an economic forecast, the evidence suggests that stock market strategists who predict bull and bear markets will have no greater success than do the economists.

Wednesday, September 28, 2011

Investor Dollars Keep Chasing Poor Performance

By Larry Swedroe

Several studies have shown investing anomalies that can’t be rationally explained by the efficient market hypothesis. Behavioral finance attempts to fill the void by explaining behaviors that shouldn’t exist. I propose a new area for research for behavioralists.

There have been many studies demonstrating that money flows follow performance, meaning that investors put their money into funds and sectors that have performed well recently. It also means investors pull their money from poor performers. This unfortunate behavior has been one of the causes of the well-documented phenomenon of investor returns being well below their very own funds. There appears to be a major exception to this rule: Despite the poor and inconsistent performance of alternative investments, investors continue to pour cash into them.

According to Morningstar, investor flows into alternative investments reached $14.7 billion in 2010, up from $10.8 billion in 2009 and just $3.4 billion in 2008. And the flows as of mid-year show that they’re on pace to match 2010’s total this year. Clearly this is a big trend.

Given the flows, you would think that the returns have been spectacular, and you would be dead wrong. As you consider the data, keep in mind that this three-year period 2008 through 2010 includes the period from July 2008 through February 2009 when the S&P 500 Index lost 41.5 percent, the very period when “alternatives” are supposed to provide risk protection. The figures represent the total return for the three-year period.

* Represented by MSCI indexes

The following represents the total return for international indices for the same period:

  • MSCI EAFE Index — -3.8%
  • MSCI EAFE Value Index — -3.4%
  • MSCI EAFE Small Cap Index — 11.2%
  • MSCI Emerging Markets Index — 14.2%

Clearly, any well-diversified portfolio would have outperformed all of the alternative strategies.

As I discuss in The Quest for Alpha, the long-term evidence on alternatives such as hedge funds is no better. Thus, the only explanations I can think of for the continued rush by investors to pour money into alternatives are:

  • Investors are unaware of the evidence.
  • While their performance is awful, the marketing machines of Wall Street are so good that they can overcome even this powerful evidence.

But perhaps the behavioralists will provide us with some alternative explanations for this bizarre and self-destructive behavior. Before you consider becoming a member of the “alternative investments club,” remember Groucho Marx’s famous line: “I don’t want to belong to any club that would have me as a member.”

Friday, September 16, 2011

Reality Show for Investors "Survivor"

By Weston Wellington

Anyone studying the long-run history of American business cannot help but observe how many of the prominent firms of one era fail to make it to the next. Free-market economies are characterized not only by intense competition but also by disruptive change. Sometimes a company’s toughest competitor turns out to be a firm it has never heard of selling a product or service that didn’t exist until recently. The list of companies that once dominated their industry but have fallen on hard times is lengthy enough to give every thoughtful investor reason for sober reflection.

Among many possible examples, a number of firms come to mind that were once highly regarded but later encountered serious or even fatal problems.

  • Bethlehem Steel pioneered the steel I-beam, which launched a skyscraper boom in cities across the country. Its engineering expertise supplied the steel sections for the Golden Gate Bridge. But growing competition and a changing marketplace eventually took their toll, and the firm filed for bankruptcy in 2001.

  • In 1973, Eastman Kodak held a seemingly impregnable position in the lucrative market for photo film and chemicals, enjoyed a reputation for innovation and astute marketing, and boasted a market value even greater than oil giant Exxon. Kodak shareholders had been favored with an uninterrupted stream of dividends dating back to 1902. Today the company is struggling to reinvent itself as the film business shrivels, the dividend has been suspended, and the share price is limping along under $3.

  • A Fortune article profiling Pfizer in mid-1998 praised it for having “one of the richest product pipelines in the Fortune 500.” A Wall Street analyst enthused that “some of my clients refer to Pfizer as the best company in the S&P 500.” In early 1999, a Forbes cover story sounded a similar note, crowning Pfizer “Company of the Year” and observing that “the people who brought us Viagra have more blockbusters on the way.” Thirteen years later, the Viagra boom has subsided, patents are expiring on highly profitable products, and the gusher investors expected from the research pipeline has slowed to a trickle. The share price has slumped over 50% since year-end 1998 compared to a 3% loss for the S&P 500 Index.

Some companies almost single-handedly create new industries but still find it difficult to turn innovation into a permanent advantage. Pan Am (air travel), Kmart (discount retailing), Polaroid (instant photography), and Wang Laboratories (word processing) all had impressive initial success and provided handsome rewards for their investors. Alas, neither Pan Am nor Polaroid survives today, and Kmart shareholders were wiped out when the firm emerged from bankruptcy in 2003. (Kmart, Polaroid, and Wang Laboratories were all cited as examples of “excellent” companies in the 1982 bestseller In Search of Excellence.)

Evidence of this “creative destruction” appears all around us. For example, the Wall Street Journal reported that shares of Minnesota-based Best Buy Co. slumped Wednesday to their lowest level since 2008 after reporting a 30% drop in quarterly profits. For most of its life, Best Buy has been the toughest kid on the block, vanquishing rivals such as Highland Superstores and Circuit City on its way to becoming the nation's leading electronics retailer.

Will Best Buy fall victim to even tougher competitors such as or Walmart? Or is this current downturn just a speed bump on the road to even greater success? No one can say. For every riches-to-rags story, we can find another tale of decline followed by dramatic recovery. According to some accounts, for example, Apple was only a few months from bankruptcy when Steve Jobs returned to the company in 1997. Now it vies with ExxonMobil for the number one spot in a ranking by market cap. And who would have imagined that a floundering New England textile firm with a low-margin business that sells suit-lining fabric would one day become a financial colossus known as Berkshire Hathaway?

The thrill of owning a great growth company during its most lucrative phase is a powerful incentive to search for the Next Big Thing. But almost every company with a highly profitable position is under constant attack from competitors seeking to garner a portion of those hefty profits for themselves.

As a result, the search for firms destined to generate greater-than-expected profits for many years into the future is fraught with peril and likely to end in frustration. Most investors will be far better off harnessing the forces of competitive markets and putting them to work on their behalf by holding a diversified portfolio. As Nobel laureate Merton Miller once observed, “Above-normal profits always carry with them the seeds of their own decay.”

Miguel Bustillo and Matt Jarzemsky, “Best Buy Gets Squeezed” Wall Street Journal, September 14, 2011.

David Stipp, “Why Pfizer Is So Hot,” Fortune, May 11, 1998.

“Pfizer: Company of the Year,” Forbes, January 11, 1999.

Standard & Poor’s Stock Guide, 1974.

Thomas Peters and Robert Waterman, In Search of Excellence (HarperCollins, 1982).

Merton Miller, “Is American Corporate Governance Fatally Flawed?” Journal of Applied Corporate Finance, Vol. 6, No. 4, Winter 1994.

Friday, August 12, 2011

ThisTime it Actually is Different

By Larry Swedroe

The massive market swings we’ve experienced this week have brought back fears of a swoon like the one we experienced in 2008. Thus, I thought it important to look at why this crisis is very different from that one.

The 2008 bear market was caused by a financial crisis that led to the financial markets “seizing up” and eventually to a severe recession. Today’s crisis isn’t even an economic crisis, let alone a financially driven one. U.S. banks are in much stronger shape today, having been forced to raise huge amounts of capital as part of the government’s “bail out” program.

A good indicator of how different things are is the TED spread, or the difference between the rate of Federal debt and the rate that banks charge to lend to each other (called the London Interbank Rate or LIBOR). LIBOR is currently around just 0.2 percent, and one-month bills yielding just 0.02 percent, meaning the spread between them is currently less than 0.2 percent At the height of the 2008 crisis, the difference between the two was nearly 4.5 percent. Such a wide spread indicated significant stress in the financial system. The capital markets had seized up, banks had to turn to the Federal Reserve to get funding, and the commercial paper market had virtually shut down. The situation was so desperate that the government had to provide guarantees on money market funds.

We don’t see any such signs of liquidity problems today, even after the downgrade. The interbank market, the commercial paper market and the repo market (which all function as ways for banks and other corporations to get the capital they need to conduct operations) are all functioning well. Each of those functioning well serves as an indicator that we’re not experiencing a financial crisis, which should be reassuring as we saw in 2008 what can happen during financial crises.

Today the financial system is much stronger as banks and investment banks alike were forced to raise large amounts of capital, the large investment banks converted to banks, and there is much less leverage in the financial system and among hedge funds as well. The reduction in leverage reduces systemic risks.

The difference in conditions helps to highlight that the problem we have today is not an economic one, but a political one. The market just needs to be convinced that our elected officials will take the necessary steps to prevent the crisis from becoming an economic one. It’s the uncertainty about the political will to act that has caused the equity market to crash, not an economic crisis.

However, just because this crisis is of a political nature, that doesn’t mean it’s any less dangerous. There’s no guarantee that all will end well. With that in mind, let’s look at some good news which you should keep in mind.

The Japanese economy has rapidly recovered, eliminating the headwinds that slowed economic growth around the world in the first two quarters.

Oil prices are down around 25 percent since hitting an intraday high of $114.83 on May 2.

Municipal Bonds
The municipal bond debacle infamously forecasted by Meredith Whitney hasn’t occurred.

Thursday, August 11, 2011

Don't Panic About the Stock Market

'The sky is falling! The sky is falling!" Chicken Little's admonition may strike many observers as particularly apt today. I disagree. This is not the market meltdown of 2008 all over again. And panic selling of U.S. common stocks will prove to be a very inappropriate response.

The sharp decline in stock prices last week has renewed fears that the economy is headed for a double-dip recession. Economic growth has been reduced to stall speed, with gross domestic product rising at less than a 1% annual rate during the first half of 2011. Real consumer spending has been negative over the past two quarters. Just as a rider risks falling over when his bicycle slows sharply, so the economy is dangerously close to slipping into recession even before a real recovery has taken hold. And now Standard & Poor's has downgraded the U.S. credit rating, citing inadequate progress in Washington on long-run budgetary problems.

The headwinds restraining the economy are many. Consumers are still over-indebted and household finances are perilously balanced. House prices, after sharp price declines, threaten to fall further. The effect has been a big hit to households' net worth and has prevented any recovery in construction activity, which normally plays a big role in the early stages of any economic expansion. The unemployment rate is stuck above 9%, and even optimistic economic forecasters see little chance of a meaningful decline, even if a tepid economic recovery resumes in the second half.

Making matters worse, Europe has not really fixed its economic problems. Growth prospects there are gloomy. In the United States, government policy is dysfunctional and powerless to help reduce unemployment. While any restraint on spending from the recent budget agreement is back-end loaded, fiscal policy is scheduled to be significantly less stimulative over coming quarters. Monetary policy, which has driven short-term rates to near zero and 10-year Treasury rates to 2.5%, appears to be out of ammunition. And, of course, the sharp decline in stock prices has a negative wealth effect and a pernicious effect on consumer confidence.

Is it time to sell all your stocks, which are still well above their lows of 2009? I think not. No one can predict what the stock market will do in this and coming weeks. Stocks may continue their decline, but I believe it would be a serious mistake for investors to panic and sell out. There are several reasons for optimism that in the long run we will see higher, not lower, market valuations.

First, I believe that stocks today are cheap. Price/earnings multiples are just over 14 and forward P/E multiples, which use forecasted earnings, have shrunk to less than 12. These multiples are low relative to historical precedent and are especially low when considered in comparison to a 10-year Treasury yield of 2.5%. Dividend yields of 2.5% also compare favorably with 10-year Treasurys. Multiples do not look cheap relative to average 10-year earnings (the so-called Shiller P/E multiples), but today's earnings are so much higher than average earnings that a 10-year average is not a good estimate of today's corporate-earning capacity.

Moreover, the structure of U.S. corporate earnings increasingly reflects economic activity abroad—including the rapidly growing emerging markets—rather than activity in the U.S. This is why corporate earnings have been growing so rapidly even though U.S. economic growth has been so tepid. For large U.S. multinational corporations, the continued growth in emerging markets will be the most important determinant of the future growth of corporate earnings. For many companies, what happens in China, India and Brazil is more important than the inability of Europe to get its house in order and the paralysis in the U.S. and Japan.

There is no doubt that our economy is in a deep hole. The huge amount of deleveraging that is necessary after the housing bubble of the early 2000s can only be accomplished over time. Fortunately, household balance sheets are improving. Debt-to-income ratios have improved considerably since 2008, though they still have far to go. Household debt-service payments relative to income have fallen sharply to levels existing in the 1980s and '90s. The recent decline in oil prices should also help consumers' financial situations. And corporate balance sheets are unusually healthy today.

Simply working off the excess housing (including the shadow inventory of foreclosure property) will take a long time to accomplish. But if there is a bright spot in the housing picture it is that housing affordability is at an all-time high. With some real improvement in the labor market we could see a substantial uptick in housing sales.

Yes, we have problems, but the current situation bears no resemblance to 2008. And for those who believe that the decline in the stock market reliably predicts a new recession, remember the famous dictum of the late economist Paul Samuelson: "The stock market has predicted nine of the last five recessions."

A strong dose of modesty is clearly in order. We all need to be aware of the limits of our ability to forecast future stock prices. No one can tell you when the stock market will end its decline, but there are some things that we do know. Investors who have sold out their stocks at times when there have been very large declines in the market have invariably been wrong. We have abundant evidence that the average investor tends to put money into the market at or near the top and tends to sell out during periods of extreme decline and volatility. Over long periods of time, the U.S. equity market has provided generous average annual returns. But the average investor has earned substantially less than the market return, in part from bad timing decisions.

My advice for investors is to stay the course. No one has ever become rich by being a long-term bear on the fortunes of the United States, and I doubt that anyone will do so in the future. This is still the most flexible and innovative economy in the world. Indeed, it is in times like this that investors should consider rebalancing their portfolios. If increases in bond prices and declines in equities have produced an asset allocation that is heavier in fixed income than is appropriate, given your time horizon and tolerance for risk, then sell some bonds and buy stocks. Years from now you will be glad you did.

Mr. Malkiel, professor emeritus of economics at Princeton University, is the author of "A Random Walk Down Wall Street" (10th edition, W.W. Norton, 2011).

Wednesday, August 10, 2011

Living With Volatility

By Jim Parker

The current renewed volatility in financial markets is reviving unwelcome feelings among many investors—feelings of anxiety, fear, and a sense of powerlessness. These are completely natural responses. Acting on those emotions, though, can end up doing us more harm than good.

At base, the increase in market volatility is an expression of uncertainty. The sovereign debt strains in the US and Europe, together with renewed worries over financial institutions and fears of another recession, are leading market participants to apply a higher discount to risky assets.

So, developed world equities, oil and industrial commodities, emerging markets, and commodity-related currencies like the Australian dollar are weakening as risk aversion drives investors to the perceived safe havens of government bonds, gold, and Swiss francs.

It is all reminiscent of the events of 2008, when the collapse of Lehman Brothers and the sub-prime mortgage crisis triggered a global market correction. This time, however, the focus of concern has turned from private-sector to public-sector balance sheets.

As to what happens next, no one knows for sure. That is the nature of risk. But there are a few points individual investors can keep in mind to make living with this volatility more bearable.

  • Remember that markets are unpredictable and do not always react the way the experts predict they will. The recent downgrade by Standard & Poor's of the US government's credit rating, following protracted and painful negotiations on extending its debt ceiling, actually led to a strengthening in Treasury bonds.

  • Quitting the equity market at a time like this is like running away from a sale. While prices have been discounted to reflect higher risk, that's another way of saying expected returns are higher. And while the media headlines proclaim that "investors are dumping stocks," remember someone is buying them. Those people are often the long-term investors.

  • Market recoveries can come just as quickly and just as violently as the prior correction. For instance, in March 2009—when market sentiment was last this bad—the S&P 500 turned and put in seven consecutive months of gains totaling almost 80 percent. This is not to predict that a similarly vertically shaped recovery is in the cards this time, but it is a reminder of the dangers for long-term investors of turning paper losses into real ones and paying for the risk without waiting around for the recovery.

  • Never forget the power of diversification. While equity markets have had a rocky time in 2011, fixed income markets have flourished—making the overall losses to balanced fund investors a little more bearable. Diversification spreads risk and can lessen the bumps in the road.

  • Markets and economies are different things. The world economy is forever changing, and new forces are replacing old ones. As the IMF noted recently, while advanced economies seek to repair public and financial balance sheets, emerging market economies are thriving.1 A globally diversified portfolio takes account of these shifts.

  • Nothing lasts forever. Just as smart investors temper their enthusiasm in booms, they keep a reserve of optimism during busts. And just as loading up on risk when prices are high can leave you exposed to a correction, dumping risk altogether when prices are low means you can miss the turn when it comes. As always in life, moderation is a good policy.

The market volatility is worrisome, no doubt. The feelings being generated are completely understandable. But through discipline, diversification, and understanding how markets work, the ride can be made bearable. At some point, value will re-emerge, risk appetites will re-awaken, and for those who acknowledged their emotions without acting on them, relief will replace anxiety.

1. World Economic Outlook, IMF, April 2011.