"The opinion of ten thousand men is of no value if none of them know anything about the subject."
-- Marcus Aurelius
Similar to Marcus Aurelius, successful value investors frequently rely upon their own reasoning process (rather than on the opinion of others), to manage their stock portfolios. After all, why should an investor jettison a stock merely because a nervous analyst or investment advisor suddenly becomes leery about the short-term prospects of a company? The same notion holds true when the vast legion of analysts all concur that an equity is a "must buy" proposition. Majority opinion may work well in a democracy but it holds no place when it comes to investing.
In fact, many investment dogmas are counterproductive to investment returns. Such notions as: dollar-cost averaging, diversification, stop-loss orders, rigid portfolio-weighting and risk tolerance strategies are designed for investors who do not know what they are doing. Yet these age-old dogmas still pervade the investment community.
John Maynard Keynes once noted: "Worldly wisdom teaches it is better for reputation to fail conventionally than to succeed unconventionally." Unfortunately for the average investor, many of the analysts that they follow and many of the advisers who manage their money, work for firms which adhere to the Keynes' decree on conventionality.
Today's discussion will address a few unproductive investment dogmas which plague the long-term success of an individual investor's portfolio.
Stocks That Pay Dividends Are Preferable for Retirees
Warren Buffett took direct aim at this faulty dogma in this year's annual letter presenting a compelling argument that selling a small percentage of your holdings in a stock that did not pay a dividend (in lieu of investing in a stock than paid a regular dividend) would result in a four percent higher net worth for the investor and a four percent higher annual payout after 10 years. The model assumed that the stock would record an annual return on equity of 12% and could be sold for a price of 125% of its equity. Both assumptions are below the normal prices and return rates of an average S&P stock. For more information see page 19 of the 2012 annual letter to shareholders. http://www.berkshirehathaway.com/letters/2012ltr.pdf
Stop-Loss Orders Provide Risk Protection for Investors
I can not think of a worse idea for investors than employing a stop-loss order. The only protection provided by the practice is possibly saving an investor the indignity of margin call and the average investor has no business employing leverage anyway.
The danger involved in employing stop-loss orders has been magnified recently by the apparent effect of programmed trading in creating "flash crashes." Countless times, nervous investors employing stop-loss orders in the name of protection, have been "stopped out" of their holdings only to see the price of their stock recover shortly after they lost their shares.
Employing stops on high volume, large-cap stocks has become risky; however, employing the practice on low volume, micro-cap stocks is tantamount to playing "Russian Roulette." Traders routinely target tiny stocks with extremely low volume and low floats to literally steal shares from risk-averse shareholders who employ the stops in the interest of protection. No micro-cap investor should every use a stop-loss under any circumstances.
Many times the practice is as easy as merely selling a few hundred shares which are bid slightly below the latest price of the stock. By eliminating the bids underneath the equity, the stock can fall precipitously in an instant and the naive investor has lost his shares. The maddening part for the novice investor is the fact that only minutes after he has lost his shares, the price quickly returns to its former level.
A Large Diversification of Stocks Protects the Investor
Sufficient diversification of equities is a good idea; however, the law of diminishing returns quickly sets in and the investor frequently holds too many stocks to monitor. To paraphrase Buffet: Diversification is only required for investors who do not know what they are doing. Both Todd Combs and Ted Weschler who now manage money for Berkshire Hathaway hold less than 10 stocks in their respective portfolios.
James Montier cites a study performed by SG Global Strategy which demonstrates that holding merely eight stocks reduces the non-market risk of holding stocks by about 83%. See Chapter 4 of “Value Investing: Tools and Techniques for Intelligent Investors” for more information.
Dollar-Cost Averaging Is a Sensible Practice
Dollar cost averaging is the practice of purchasing small amounts of stock or mutual funds on a predefined basis until a designated amount of investment money is exhausted. The practice has long been advocated by Suze Orman among others. For instance, an investor who wishes to hold stocks long term in the form of an S&P index fund might purchase a few shares once a month until his desired allotment is purchased. The theory holds that the practice protects the investor from purchasing shares when the price may be at a premium. It also assumes that the investor holds no conception of value and/or is a "nitwit."
The problem with dollar cost averaging is obvious; it assumes that the investor lacks the ability and the will power to purchase stocks when they drop to a level below their intrinsic value. It is a defense mechanism which eliminates an investor's biggest edge, specifically, his or her ability to pull the trigger when valuations are at their most desirable points.
Volatile Stocks Are Extremely Risky
The aforementioned truism is likely a derivation of the faulty assumption that volatility in equities is commensurate to risk. In other words, lower risk stocks can be defined as ones which tend to exhibit less price volatility. To quote James Montier: "Risk shouldn't be defined as standard deviation (for volatility). I never met a long-only investor who gives a damn about upside volatility."
Simply stated, downward volatility invariably decreases the risk in an investment, while upward volatility increases the risk in an investment. While it is clear that all stocks which drop to multiyear lows are not sound investments, it is equally clear that as a rule, stocks trading at multiyear lows are less risky propositions than their counterparts which are trading at multiyear highs.
I give the final word on this subject to Benjamin Graham: "It is our argument that a sufficiently low price can turn a security of mediocre quality into a sound investment opportunity--provided that the buyer is informed and experienced and that he practices adequate diversification."
In Graham’s view, investment risk is more a matter of whether the security contains a margin of safety, and a margin of safety is generally a function of a falling price.
Summary
To outperform the market in the long term, an investor must perform two functions on a regular basis. First and foremost, he/she must routinely buy securities that are trading below their intrinsic value, thus holding a sufficient margin of safety. Second, the investor must look in the mirror to understand who is ultimately responsible for the success of their own portfolio.
It is impossible to outperform the market if one becomes the market. Adhering to accepted investment dogma dooms an investor to a fate of market performance or worse. Such individuals are better served investing in index funds while pursuing a less agonizing hobby.
Alas, the problem does not begin and end with individual investors; unfortunately, the vast majority of fund managers and investment advisers suffer from the same affliction. Rarely do investment firms want free-thinkers in their house. Such individuals create an air of general discomfort and should they suffer from a temporary performance lapse, their unconventional nature is deemed to be the culprit.
I close today's discussion with an enlightening quote from G.K Chesterton:
"Dogma does not mean the absence of thought, but the end of thought."
-- Marcus Aurelius
Similar to Marcus Aurelius, successful value investors frequently rely upon their own reasoning process (rather than on the opinion of others), to manage their stock portfolios. After all, why should an investor jettison a stock merely because a nervous analyst or investment advisor suddenly becomes leery about the short-term prospects of a company? The same notion holds true when the vast legion of analysts all concur that an equity is a "must buy" proposition. Majority opinion may work well in a democracy but it holds no place when it comes to investing.
In fact, many investment dogmas are counterproductive to investment returns. Such notions as: dollar-cost averaging, diversification, stop-loss orders, rigid portfolio-weighting and risk tolerance strategies are designed for investors who do not know what they are doing. Yet these age-old dogmas still pervade the investment community.
John Maynard Keynes once noted: "Worldly wisdom teaches it is better for reputation to fail conventionally than to succeed unconventionally." Unfortunately for the average investor, many of the analysts that they follow and many of the advisers who manage their money, work for firms which adhere to the Keynes' decree on conventionality.
Today's discussion will address a few unproductive investment dogmas which plague the long-term success of an individual investor's portfolio.
Stocks That Pay Dividends Are Preferable for Retirees
Warren Buffett took direct aim at this faulty dogma in this year's annual letter presenting a compelling argument that selling a small percentage of your holdings in a stock that did not pay a dividend (in lieu of investing in a stock than paid a regular dividend) would result in a four percent higher net worth for the investor and a four percent higher annual payout after 10 years. The model assumed that the stock would record an annual return on equity of 12% and could be sold for a price of 125% of its equity. Both assumptions are below the normal prices and return rates of an average S&P stock. For more information see page 19 of the 2012 annual letter to shareholders. http://www.berkshirehathaway.com/letters/2012ltr.pdf
Stop-Loss Orders Provide Risk Protection for Investors
I can not think of a worse idea for investors than employing a stop-loss order. The only protection provided by the practice is possibly saving an investor the indignity of margin call and the average investor has no business employing leverage anyway.
The danger involved in employing stop-loss orders has been magnified recently by the apparent effect of programmed trading in creating "flash crashes." Countless times, nervous investors employing stop-loss orders in the name of protection, have been "stopped out" of their holdings only to see the price of their stock recover shortly after they lost their shares.
Employing stops on high volume, large-cap stocks has become risky; however, employing the practice on low volume, micro-cap stocks is tantamount to playing "Russian Roulette." Traders routinely target tiny stocks with extremely low volume and low floats to literally steal shares from risk-averse shareholders who employ the stops in the interest of protection. No micro-cap investor should every use a stop-loss under any circumstances.
Many times the practice is as easy as merely selling a few hundred shares which are bid slightly below the latest price of the stock. By eliminating the bids underneath the equity, the stock can fall precipitously in an instant and the naive investor has lost his shares. The maddening part for the novice investor is the fact that only minutes after he has lost his shares, the price quickly returns to its former level.
A Large Diversification of Stocks Protects the Investor
Sufficient diversification of equities is a good idea; however, the law of diminishing returns quickly sets in and the investor frequently holds too many stocks to monitor. To paraphrase Buffet: Diversification is only required for investors who do not know what they are doing. Both Todd Combs and Ted Weschler who now manage money for Berkshire Hathaway hold less than 10 stocks in their respective portfolios.
James Montier cites a study performed by SG Global Strategy which demonstrates that holding merely eight stocks reduces the non-market risk of holding stocks by about 83%. See Chapter 4 of “Value Investing: Tools and Techniques for Intelligent Investors” for more information.
Dollar-Cost Averaging Is a Sensible Practice
Dollar cost averaging is the practice of purchasing small amounts of stock or mutual funds on a predefined basis until a designated amount of investment money is exhausted. The practice has long been advocated by Suze Orman among others. For instance, an investor who wishes to hold stocks long term in the form of an S&P index fund might purchase a few shares once a month until his desired allotment is purchased. The theory holds that the practice protects the investor from purchasing shares when the price may be at a premium. It also assumes that the investor holds no conception of value and/or is a "nitwit."
The problem with dollar cost averaging is obvious; it assumes that the investor lacks the ability and the will power to purchase stocks when they drop to a level below their intrinsic value. It is a defense mechanism which eliminates an investor's biggest edge, specifically, his or her ability to pull the trigger when valuations are at their most desirable points.
Volatile Stocks Are Extremely Risky
The aforementioned truism is likely a derivation of the faulty assumption that volatility in equities is commensurate to risk. In other words, lower risk stocks can be defined as ones which tend to exhibit less price volatility. To quote James Montier: "Risk shouldn't be defined as standard deviation (for volatility). I never met a long-only investor who gives a damn about upside volatility."
Simply stated, downward volatility invariably decreases the risk in an investment, while upward volatility increases the risk in an investment. While it is clear that all stocks which drop to multiyear lows are not sound investments, it is equally clear that as a rule, stocks trading at multiyear lows are less risky propositions than their counterparts which are trading at multiyear highs.
I give the final word on this subject to Benjamin Graham: "It is our argument that a sufficiently low price can turn a security of mediocre quality into a sound investment opportunity--provided that the buyer is informed and experienced and that he practices adequate diversification."
In Graham’s view, investment risk is more a matter of whether the security contains a margin of safety, and a margin of safety is generally a function of a falling price.
Summary
To outperform the market in the long term, an investor must perform two functions on a regular basis. First and foremost, he/she must routinely buy securities that are trading below their intrinsic value, thus holding a sufficient margin of safety. Second, the investor must look in the mirror to understand who is ultimately responsible for the success of their own portfolio.
It is impossible to outperform the market if one becomes the market. Adhering to accepted investment dogma dooms an investor to a fate of market performance or worse. Such individuals are better served investing in index funds while pursuing a less agonizing hobby.
Alas, the problem does not begin and end with individual investors; unfortunately, the vast majority of fund managers and investment advisers suffer from the same affliction. Rarely do investment firms want free-thinkers in their house. Such individuals create an air of general discomfort and should they suffer from a temporary performance lapse, their unconventional nature is deemed to be the culprit.
I close today's discussion with an enlightening quote from G.K Chesterton:
"Dogma does not mean the absence of thought, but the end of thought."
