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The Single Greatest Mistake Investors Make

The single greatest mistake investors make is to extrapolate recent history out into the future. They take the financial returns of the past 5 days or 5 years or even 50 years and assume the next few days or years will look just the same without any consideration for the historical context or conditions that provided for those returns.

They forget that, while ‘history may rhyme, it doesn’t repeat itself’ (Twain). Or that, “the only thing that is constant is change” (Heraclitus). These two famous quotes apply to the financial markets as much as anything.

Ignoring these truths and instead simply extrapolating is why investors are suckered into pouring money into the stock market only after a run of great performance. They believe that the recent gains are about to repeat to their great benefit when they should be thinking about what conditions allowed for those gains to take place and analyzing whether they are still relevant or not.

This is also why they are suckered into selling only after a painful decline as they did at the lows made during the financial crisis. They believe that they are about to suffer another 50% decline on top of the one they just endured when they should really be reminding themselves that change is the only guarantee in life.

I believe this is one of the biggest problems with so-called “passive” investing. It is built upon the faulty premise that it is ‘impossible to forecast’ the future returns of any asset class over any period of time so we should just own all of them all the time. My response to this is that while ‘ignorance may be bliss’ it’s not a valid investment strategy.

In his 1992 letter to Berkshire Hathaway shareholders, Warren Buffett wrote:

We’ve long felt that the only value of stock forecasters is to make fortune tellers look good. Even now, Charlie and I continue to believe that short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also from grown-ups who behave in the market like children. However, it is clear that stocks cannot forever overperform their underlying businesses, as they have so dramatically done for some time, and that fact makes us quite confident of our forecast that the rewards from investing in stocks over the next decade will be significantly smaller than they were in the last.

Much can be learned from this short passage. First, short-term stock market forecasts are, indeed, nearly worthless – essentially a guessing game. Second, long-term forecasts, on the other hand, can be made with ‘confidence.’ “How?” you ask.

It’s actually very simple. Rather than fixate on recent history and extrapolate it into the future you must abandon this natural tendency. And as I said earlier you also need to analyze the conditions that allowed for those returns to see whether they are still relevant to today’s market.

In Buffett’s example he’s referring to the wonderful returns equity investors experienced from 1982-1992. During that span investors roughly quadrupled their money. Over the coming decade they merely doubled their money so Buffett was right that the decade beginning in 1993 would fall far short of the return of the prior decade even it they were still very good.

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But Buffett made another prescient forecast in November 1999 when he wrote:

Today, staring fixedly back at the road they just traveled, most investors have rosy expectations. A Paine Webber and Gallup Organization survey released in July shows that the least experienced investors–those who have invested for less than five years–expect annual returns over the next ten years of 22.6%. Even those who have invested for more than 20 years are expecting 12.9%. Now, I’d like to argue that we can’t come even remotely close to that 12.9%… you need to remember that future returns are always affected by current valuations and give some thought to what you’re getting for your money in the stock market right now.

You probably already know that stock market returns from 1999 to 2009 were not very kind to investors.

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And Buffett tells us how he was so confident that this would be the case. He examined the conditions that allowed for returns to be so wonderful from 1982-1999 but were no longer present in 1999: wonderful valuations. Stocks were so cheap in 1982 that the coming decade was virtually guaranteed to be better than the decade that preceded it. (1972-1982 was another decade that was not fun for investors.) Then in 1999 valuations were so expensive that there was almost no possibility of decent returns going forward.

So let’s take a look at Buffett’s favorite valuation yardstick which he refers to on both of those prior writings. It tracks the total value of the stock market in relation to Gross National Product.

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From the chart, it’s plain to see that valuations were extremely attractive back in the early 1980’s. This is why stocks performed so well over the next 20 years. However, I find it absolutely fascinating that stock market valuations today are essentially equivalent to valuations in November 1999 when he wrote that latter passage. Yeah, go back and read that last line again. It’s a doozy and it’s absolutely fact.

This is also why the past 5 years or even the past 50 years are totally irrelevant to equity investors in today’s market. There is almost zero possibility today of achieving a return anywhere close to what those historical returns represent. So shun forecasts if you want. Plead ignorance if it makes you feel blissful. But at today’s valuations you should at least be aware of the fact that it’s exceedingly dangerous to fall into the trap of extrapolating without analyzing.

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Tweet Storm: Are Mom & Pop Smarter Than Jeff Gundlach And Warren Buffett?

It’s not rocket science, folks. You just have to control your emotions, tune out Wall Street’s propaganda machine and try to see the facts for what they are.

Related:

How to time the market like Warren Buffett

Don’t buy the buy and hold line of BS

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Greatest Hits 2014

Here are the most popular TFR posts of 2014:

  1. Why Mr. Market Is Still Wrong About Apple
  2. This Is Probably The Second Worst Time In History To Own Stocks
  3. For Everyone Who Thinks Tom DeMark’s 1929 Analog Is A Joke…
  4. How To Time The Market Like Warren Buffett
  5. ATTN: DUMB MONEY – The Smart Money Is Selling To You (Yet Again)
  6. Don’t Believe The Hype Of Rising Interest Rates
  7. The New Wolves Of Wall Street
  8. Seeing The Forest For The Trees
  9. The Creative Destruction Of Wall Street
  10. The Problem With Index Funds

So we were bullish on Apple (up 70%) and bullish on bonds (up 20%) and bearish on stocks (up 15%). Well, two out of three ain’t bad.

Thanks for reading. I wish you a very profitable new year!

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How To Handle An Environment Of “Low Returns”

First off, if you are expecting to achieve historical average rates of return from stocks or bonds from current prices please go read, “How To Time The Market Like Warren Buffett.” The bottom line is a 10-year treasury note pays you little more than 2% per year and stocks are likely to earn you even less over the next decade. So what’s a prudent investor to do? Here’s Howard Marks on your options:

How might one cope in a market that seems to be offering low returns?

  • Invest as if it’s not true. The trouble with this is that “wishing won’t make it so.” Simply put, it doesn’t make sense to expect traditional returns when elevated asset prices suggest they’re not available. I was pleased to get a letter from Peter Bernstein in response to my memo, in which he said something wonderful: “The market’s not a very accommodating machine; it won’t provide high returns just because you need them.”
  • Invest anyway — trying for acceptable relative returns under the circumstances, even if they’re not attractive in the absolute.
  • Invest anyway — ignoring short-run risk and focusing on the long run. This isn’t irrational, especially if you accept the notion that market timing and tactical asset allocation are difficult. But before taking this path, I’d suggest that you get a commitment from your investment committee or other constituents that they’ll ignore short-term losses.
  • Hold cash — but that’s tough for people who need to meet an actuarial assumption or spending rate; who want their money to be “fully employed” at all times; or who’ll be uncomfortable (or lose their jobs) if they have to watch for long as others make money they don’t.
  • Concentrate your investments in “special niches and special people,” as I’ve been droning on about for the last couple of years. But that gets harder as the size of your portfolio grows. And identifying managers with truly superior talent, discipline and staying power certainly isn’t easy.

The truth is, there’s no easy answer for investors faced with skimpy prospective returns and risk premiums. But there is one course of action — one classic mistake — that I most strongly feel is wrong: reaching for return.

-Howard Marks, “There They Go Again,” May 6, 2005

Clearly, investors are currently “reaching for return” like never before. I have no doubt this episode will any any differently than it has in the past. For prudent investors, however, I think the best options are currently either 3 or 4, so long as they understand all the pros and cons of each.

Choosing the third option means you should be willing to tolerate another decline of up to 50% over the next decade in an attempt to capture the low single-digit returns stocks currently offer. That’s just the simple risk/reward equation current valuations present investors with.

Choosing the fourth option means you may have to hear your friends brag about their gains for a while should the market witness another bubblicious blow off akin to the 1998-1999 episode.

Which is the lesser of the two evils for you? Neither are very appealing but that’s the name of the game when you’re playing financial market limbo.

For more Howard Marks I highly recommend you read his excellent book, “The Most Important Thing

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The Worst Trade Of My Life

“The only thing to do when a person is wrong is to be right, by ceasing to be wrong. Cut your losses quickly, without hesitation. Don’t waste time.” -Jesse Livermore

This morning I closed out the worst trade of my life. Corinthian Colleges stock price is up about 100% this week on news that its creditors aren’t going to immediately force them into bankruptcy. But that doesn’t even come close to making up for the losses I’ve suffered over the past three years.

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It began back in 2011 when I first started buying the stock. At the time, it looked cheap because the for-profit industry was facing two major challenges that hurt Corinthian even more than most of its competitors. First, the industry was heading into what appeared to me to be a cyclical downturn as the economy began to improve and those who were out of work became less interested in learning new skills or burnishing their resumes. Second, the federal government was unhappy with the industry’s business practices and started devising and implementing more regulatory restraints for the companies.

What I totally miscalculated was that it’s probably a secular decline, not a cyclical one, for the industry. AND the government was fully prepared to put a company like Corinthian out of business. To make things worse, the stock price tried to tell me this for three years and I just wouldn’t listen.

“The inability to read a tape and spot trends is also why so many in the relative-value space who rely solely on fundamentals have been annihilated in the past decade.” -Paul Tudor Jones

Guilty as charged, Paul. What I’ve learned – the hard way – from all of this: What the best traders and investors in the world perhaps do best is admit when they’re wrong and take a loss quickly.

Warren Buffett’s recent Tesco trade is a great example of this. A few weeks ago it was revealed that the company, the largest grocery store operator in the UK, is now being investigated for accounting fraud. Buffett began dumping his shares almost immediately, roughly a quarter-million of them, in fact, calling the investment a, “huge mistake.”

Buffett’s speed and decisiveness in cutting this loss should be an inspiration to investors. In fact, I believe that even if you don’t have the greatest possible investment or trading process to begin with (just a decent one), if you have a terrific plan for selling that involves cutting losses quickly and ruthlessly, you can generate alpha (outperformance) solely that way (by losing less when markets fall). That’s how critical it is.

Moreover, it doesn’t need to be based solely on fundamental developments as Buffett’s sale seems to be. The trend in Corinthian over the past three years was plain as day. In fact, while I owned it, it rarely spent any time at all above its 200-day moving average. Outside of late 2011, early 2012 it didn’t really ever make any higher highs and higher lows. The trend over the past two years was almost screaming, “this stock is a loser! Get out while you can!!”

The bottom line is this: We all will make mistakes in the markets. What separates the best from the rest is how they deal with them and then how they learn from them and adapt their methods going forward. This was the worst trade of my life. I’ll never forget it because, although it had to literally beat me over the head, this lesson has now been lodged firmly in my brain.

So if you learn anything at all from Jesse Livermore, Paul Tudor Jones, Warren Buffett or from my painful mistake, I hope it’s this: Recognize when you’ve made a mistake and sell immediately. And pay attention to the trend. If it doesn’t validate your thesis, move on to your next idea.

“There is no better test of a man’s integrity than his behavior when he is wrong.” ―Marvin Williams

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Two Similes

A couple more thoughts on “The New Wolves of Wall Street“:

  • The main reason for using index funds is to reduce costs. If that’s the case then why add a high-cost advisory fee on top? Doesn’t that defeat the entire purpose?! If asking your stock broker if you need to trade something is like asking the barber if you need a haircut (to steal a Buffett line), then an adviser pitching index funds with a fat advisory fee is like a barber telling a bald guy, “okay, you can shave at home but keep the regular checks coming, okay?”
  • Many of these advisers will say that just because they’re using index funds doesn’t mean they’re not providing valuable advice. It’s true that some are but some will argue that you pay them to close the “behavior gap.” In other words, “you pay me to protect you from yourself.” To me this sounds a lot like, “I’m the wiseguy who provides protection in this neighborhood. If you don’t pay me how can I keep you safe?”
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A Holistic Approach To Market Timing That Crushes Buy-And-Hold

This is part 3 in my market timing series that began with “How To Time The Market Like Warren Buffett”:

“…the big money… is not in reading the tape but in sizing up the entire market and its trend.” -Jesse Livermore, Reminiscences of a Stock Operator

That’s exactly what I’ve been doing with my market timing series over the past few weeks: “sizing up the entire market.” But I haven’t yet gotten to the “trend” part – which, as Jesse testifies, is absolutely critical.

Before I get to that let’s just briefly recap how we got here. I first looked at Warren Buffett’s favorite valuation yardstick to get an idea of how stocks were valued. Comparing the prospective return from stocks (as forecast by the market cap-to-GDP model) to the simple yield on the 10-year treasury note gives us a great idea of which asset class we should own at any given time: the one the offers the greater prospective return! Voila, we have a very successful market-timing model. (See “How to Time The Market Like Warren Buffett“)

Then I looked at a measure of investor sentiment as the basis of a similar model. When I wrote it, I used Buffett’s famous ‘fear and greed’ quote. Since then, however, I really think this one from Sir John Templeton is even more apt: “Help people. When people are desperately trying to sell, help them and buy. When people are enthusiastically trying to buy, help them and sell.” Anyhow, this model worked in a very similar manner to our fundamental model and both had similarly successful results. (See “How to Beat The Market By Being Fearful When Others Are Greedy“)

At the end of the day, the thing that made both of these models successful was helping our hypothetical market timer avoid major bear markets. Where they suffered was when they got our market timer out of stocks (or back into stocks) too early (something that is all too common for the fundamentally-focused investor like yours truly). This is where the trend comes in.

Inspired by the likes of Meb Faber, Cliff Asness and Michael Covel, I’ve been studying trend following for a few months now. Maybe the most common indicator of the intermediate-term trend (1-3 years) that I’ve found is the 200-day moving average. This is simply the average of the last 200 days’ closing prices. A closing price above the average signals an uptrend; a closing price below signals a downtrend.

Many studies have shown that when an investor simply adds a trend-following component to their portfolio using this indicator for the S&P 500 they can reduce drawdowns, aka losses during bear markets, and improve overall results. Depending on transaction costs and taxes, however, the benefits may be negligible. But because I prefer a more holistic approach, I decided to look at what would happen if our hypothetical market timer added this simple trend-following approach to our existing models.

Here’s how it works. Our hypothetical market timer annually (at year-end) checks the 10-year forecast returns provided by our fundamental and our sentiment models and compares them to the yield on the 10-year treasury note. If both models suggest stocks offer the best return she does nothing; she merely holds the stocks she already owns. Should one of the models, however, suggest that the 10-year treasury offers a better return she… doesn’t sell her stocks and buy bonds just yet.

This is where she becomes a trend-follower. On a monthly basis, she begins checking the S&P 500’s 10-month moving average (roughly the same as the 200-dma but easier for me to calculate with the data available) and watches for a close below that level. Should the index close below its 10-month moving average while one of our models suggest stocks are not attractive she shifts from stocks to cash. Here are the results. This strategy is in yellow, labeled “Fundy-Trend.”

Screen Shot 2014-08-26 at 11.15.03 AMSo from 1950-2014 our buy and hold investor turns $1,000 into $785k (if she can hang on through the big drawdowns). Our straight trend-following friend finishes with $690k (using the method Jeremy Siegel uses in “Stocks For The Long Run“). Our fundamental market timer finishes with $1.56 million (compared to $1.15m for our fundamental model and $1.25m for our sentiment models alone), almost twice as much as the buy and hold investor.

Not bad, eh? But what’s that green one that’s over $2.2m?! Well check this out: I also decided to see what would happen if our hypothetical market timer, instead of going to cash, decided to shift from owning stocks to getting short stocks once the trend turned down. Clearly, she kicks everyone’s ass. She makes nearly 3x as much as our buy and hold investor, 2x as much as our simple fundamental and sentiment market timers and more than 40% more than our holistic (fundamental, sentiment and trend) market timer.

Warren Buffett, Sir John Templeton and Jesse Livermore weren’t successful for no reason. They individually used fundamentals, sentiment or the trend to crush the markets. Putting them together into a simple, quantitative and holistic process yields similarly spectacular results. So don’t buy the buy and hold line of BS if it doesn’t suit you. There are systematic ways like this to protect yourself from large losses and enhance your overall returns.

Soon I’ll be putting up a page on this site to keep track of these models. But again, I’d like to emphasize that this is merely for educational purposes. It doesn’t include transaction costs or taxes which should be major considerations for real-world investing scenarios.

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