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Friday, 6 March 2009

Fundamental Indexing Can’t Save You from Aliens

(But Can Protect You From Nearly Everything Else)

William Bernstein, in The Four Pillars of Investing, states: “About once every generation, the markets go barking mad. If you are unprepared, you’re sure to fail”.

As indices crumble and even experienced investors start to capitulate the stockmarkets are flashing a big message to anyone with an appreciation of stockmarket history and the ability to ride out the storm. Welcome to the test of our generation.

Good Investing Is Not About Social Conformance

From personal experience, I can guarantee that there’s one sure sign that the stockmarket is doing badly. It’s when your dearly beloved, who normally has as much interest in the state of your investments as Ellen Degeneres has in Bruce Willis, sidles up to you, lovingly nibbles an earlobe and whispers in your ear “so, how much money have you lost so far?” That’s real pressure – and note the obligatory “you” in the question. This is not a shared experience.

The social forces that conspire to make us conform are a significant factor in the way investors react to major market movements. We make our money together, when markets are charging upwards, like a pack of hungry wolves. When they fall, though, we lose alone, as popular as a skunk with halitosis. It’s as hard to ignore these invisible - but real - pressures as it is to suppress the innate psychological triggers that tell us to run from pain. If you really want to make money by investing in stocks these mental blocks have to be overcome.

Stocks For The Long Run, Baked Beans For The Short

Preparation for the test is all important. The basic trick is to recognise that stockmarkets essentially track the long-term growth of the global economy. It’s an imperfect relationship and often gets wildly out of kilter but in the end the market will trend back in line because, in a real sense, the market is the economy.

If you believe that the growth that the world has seen since the end of the eighteenth century is destined to soon end permanently then investing in the stockmarket is not for you. You’d be better off buying a lifetime’s supply of baked beans, a large selection of semi-automatic weapons and hiding in a cave. Otherwise shares offer the best way of protecting ourselves against the unknown unknowns that face us.

In fact the only thing stocks can’t protect us against in the long-term is the possibility of the total collapse of our nation state or annihilation of the planet. While the odds on the latter maybe aren’t as long as we’d like them to be, on account of our careless stewardship of the environment, unfortunate habit of giving nuclear materials to unstable regimes led by crazed monomaniacs and reckless creation of bio-engineered superbugs, it’s probably reasonable to discount this in our investment plans.

The collapse of any particular nation state is more of a concern – Argentina, Germany and Japan were amongst the great powers in 1900 that saw their investors completely wiped out by mid-century. Not all citizens have had the continuity of the Americans and British.

Stock Volatility Over Time

Aside from this, though, investing in stocks is about as safe a bet as you can make, as long as you can take a very long term view. Burton Malkiel in A Random Walk Down Wall Street shows that for a single year between 1950 and 2002 a US investor could see a variation in return between 50% up and 25% down. It’s also the case that very good up years and very bad down years tend to cluster together. In 1973 and 1974 the UK stockmarket lost 75% of its value. It then bounced back 70% in 1975 when most investors had lost all hope and sold out. The volatility of stockmarket investing over any single year can be stomach churning.

However, the longer out you look the lower the volatility becomes. By the time you get to twenty five years Malkiel shows that the variation of worst to best over any quarter century was between 8% to 17%. So all stockmarket investors over all twenty five year periods across the second half of the twentieth century would have made a positive return, even if they had invested all of their money at the worst possible time. Of course, the worst possible time to have invested would have been just as the stockmarket peaked, just when no one could see any possibility of anything other than gains for evermore.

The Paradox of Stockmarket Investing

There’s the paradox of stockmarket investing – the worst time to invest is when it’s doing well and the best time is when it’s doing badly. Unfortunately, as we travel our lives in a tiny bubble of space and time we can’t predict the future with any great accuracy so we can’t say if Malkiel’s historical observations will be repeated in the twenty first century. Not exactly, that’s for sure. However, it does give us some clues.

We should look to invest in shares when the stockmarket is doing badly. We should look to spread our investments over time because we can never be sure that it won’t do even more badly in future. Unless we are remarkably clever stock analysts (a breed that seems to be curiously absent at the moment) we should spread our investments across a wide range of stocks and we should think about having some international exposure in case our own country implodes.

As yet extra-terrestrial diversification isn’t available to us but no doubt Richard Branson’s working on that. Above all we shouldn’t invest money we will need in the next five, maybe ten years – stockmarket investing only provides something close to a guarantee of good returns over long periods, anything less is a gamble.

Overcoming The Index Fund's Bias to Hot Stocks

Regular investment in a basic index tracker is the obvious way to achieve these aims. However, regular index trackers are weighted by market capitalisation so that bigger companies constitute a larger percentage of the overall fund. This means that if hot money flows into a stock or sector the relative weighting of the index fund to overvalued companies and sectors grows. The same effect happens in reverse to companies that may be temporarily out of fashion.

Various attempts have been made to develop instruments to overcome this “problem”, based around weighting the stocks held on some fundamental factors other than market cap. Fama and French’s three factor model stresses the excess returns of both small market cap and low book to price stocks, Arnott’s four factor model is focussed on dividends, sales, book value and income while Siegel has argued for weightings based on dividends or dividend forecasts. All of these suggestions have, in back-testing, been shown to outperform standard market cap weighted indices.

Preparing for Mad Markets

So should we adopt such funds? Well, unfortunately we don’t live in the past and back-testing often spectacularly backfires. Virtually every stockmarket trend that ever there was has ended just about as soon as some commentator or other has pointed it out. So there can be no guarantee that the same won’t happen to fundamentally weighted index trackers. Additionally these funds tend to attract slightly higher costs than their more staid cousins in part because they’re not quite so passive and require a bit more management.

Those caveats aside, fundamentally weighted index trackers offer the investor an additional weapon in their armoury. Getting beneath the rhetoric, they’re trading on the so-called value effect which is, more or less, that shares that have underperformed in the past will tend to outperform in future. Fundemental indexing aims to capture such outperformance at lower volatility so if you’re building a portfolio to try to prepare yourself against the worst that inflation, governments and mad scientists can throw at you then they have a part to play.

Just don’t expect them to save you from alien invasion as well.

Further Reading on Fundamental Indexing:

Rob Arnott:

Munro Fund Money Matters:

Fama & French:

Jeremy Siegel:

1 comment:

  1. Hello - would you mind pointing out a few worthwhile index trackers that utilize some type of weighting strategy as mentioned above?

    Thanks a ton