Ron Lieber's recent New York Times
column provided a great example of just how difficult it is to beat the market. He asked Wilshire Associates to look back 30 years to the beginning of the bull run in stocks and figure out which of the companies in its index of more than 5,000 American businesses had performed best over that stretch. One surprise: Most investors are unlikely to have heard of five of the 10 best performers (I know I hadn't): Here they are:- Danaher (DHR, #3 on the list)
- Apco Oil & Gas (APAGF, #4)
- Precision Castparts (PCP, #7)
- Raven Industries (RAVN, #8)
- HollyFrontier (HFC, #10)
And the No. 1 performer wasn't some high-tech or biotech firm, but rather Home Depot (HD)! The top 10 stocks earned annualized returns of 21-26 percent. To earn those returns, you would've had to find those needles in the market haystack and had the discipline and courage to hold on for 30 years. Good luck.
The following is another great example of the folly of trying to pick individual stocks. Can you name the stock that for the 20-year period ending in 2006 outperformed Berkshire Hathaway (BRK) by an astounding 4.5 percent a year? It's none other Bear Stearns! Consider a story about the investment bank, which foundered following the housing crash and was acquired by JPMorgan Chase (JPM) in 2008, appeared in Barron's in 2004. The author noted that "with the company's low-risk profile and strong controls, investors in Bear Stearns can sleep well, knowing that even a full-blown financial crisis is unlikely to cripple the firm."
In January 2007, the stock hit an all-time high of $171. We can only wonder how many Bear Stearns employees had significant portions of their net worth tied up in company stock because they "knew" what a great company it was. And surely they would know if there were problems arising and have sufficient time to exit. It's also safe to assume that those same employees wouldn't have invested in Bear Stearns stock if they were employed elsewhere. Bear Stearns was not any safer because the individuals happened to work there. And for senior management, they may even have an illusion of the ability to control events.
In other words, the prudent strategy is to diversify all of your assets, including your labor capital. And while the surest way to get rich is to concentrate your assets, it is also the surest way to go broke. While investors who had concentrated positions in Bear Stearns suffered greatly, investors who owned market-like global portfolios had a small fraction of 1 percent of their assets in Bear Stearns stock, even when it traded at its peak. This is a clear demonstration of the importance of diversifying stock risks. Unfortunately, as sure as death and taxes, despite the lesson Bear Stearns provided, this same mistake will be repeated many times over by future investors.
There's an overwhelming body of evidence that demonstrates that persistently beating the market on a risk-adjusted basis is extremely hard to do. This holds true for individual investors, mutual funds, pension plans, and especially hedge funds. In fact, there's no evidence that any outperformance is more than a random outcome.
The following is one of my favorites on just how difficult it is to persistently pick winning stocks. The 1990s witnessed one of the greatest bull markets of all time. Yet 22 percent of the 2,397 U.S. stocks in existence throughout the decade had negative returns. Not negative real returns, but negative absolute returns. Even this shocking figure is inaccurately low. The reason is that it includes only stocks that were in existence throughout the decade -- there's "survivorship bias" in the data.
Stocks are much riskier than investors believe. The reason is that stock returns aren't normally distributed -- the dispersion of individual stock returns doesn't resemble a bell curve where the median return is the same as the mean return. If the dispersion of individual stock returns resembled the bell curve, the returns of half the stocks would be above the mean and half would fall below the mean. However, this isn't the case because while your profits are unlimited, you can only lose 100 percent.
Thus, a few big winners cause the average return to be above the median return. As a result, there are more stocks that have below-"average" returns than there are stocks with above-average returns. Along with the high efficiency of the markets in processing information, this makes the purchase of individual stocks a loser's game. Let's take a deeper look at why this is the case, beginning with the risks investing in stocks entails.
Stock investors face several types of risk. First, there's the idiosyncratic risk of investing in stocks. Second, various asset classes carry different levels of risks. Small-cap stocks are riskier than large-caps, and value stocks are riskier than growth stocks. These two risks -- size and value -- can't be diversified away. Thus, investors must be compensated for taking them. The third type of stock risk is that of the individual company.
The risks of individual stock ownership can easily be diversified away by owning passive asset class or index funds that basically own all the stocks in an entire asset class or index. Each of these vehicles eliminates the single-company risk in a low-cost and relatively tax-efficient manner. Note that asset-class risk can also be addressed by the building of a globally diversified portfolio, allocating funds across the various asset classes of domestic and international, large and small, value and growth, real estate, and emerging markets.
The benefits of diversification are obvious and well-known. Diversification reduces the risk of underperformance. It also reduces the volatility and dispersion of returns without reducing expected returns. Thus, a diversified portfolio is considered to be more efficient than a concentrated portfolio. The problem is that most investors fail to diversify. This failure has its roots in two distinctly different sources: lack of knowledge and human behavioral traits.
Because most investors haven't studied financial economics, read financial economic journals or read books on modern portfolio theory, they don't have an understanding of how many stocks (hundreds, if not thousands) are really needed to build a truly diversified portfolio. Similarly, they don't have an understanding of the nature of how markets and stocks behave in terms of risks and rewards (the issue of compensated versus uncompensated risk). The result of the lack of knowledge is that most investors hold portfolios with assets concentrated in relatively few holdings.
Investors also fail to diversify because they make behavioral mistakes. Among the most common are:
- Overconfidence: Even when individuals know that it's hard to beat the market, they're confident that they will be among the few who succeed.
- Confuse the familiar with the safe: They believe that because they're familiar with a company, it must be a safer investment than one with which they're unfamiliar. Being familiar with a company creates the illusion that the information they have is "value relevant" -- not already incorporated into prices.
- Believe that by limiting the number of stocks they hold, they can manage their risks better: It's just an illusion, another form of overconfidence.
- Owing individual stocks provides a false sense of control over the outcomes by being involved in the process of stock selection. It's the portfolio's asset allocation that matters, not who's controlling the switch.
Investors are rewarded with higher expected returns for taking systematic risks, risks which can't be diversified away. With equities there are three types of risk:
- Beta (exposure to the overall stock market)
- Size (exposure to small-cap stocks)
- Value (exposure to stocks with high book-to-market or low P/E ratios)
The academic research makes clear that the majority of a portfolio's returns are determined by its exposure to these risk factors, not stock selection. That makes individual stock selection a loser's game.
If you happen to own Facebook, having bought it at the IPO expecting an immediate profit, here is my advice: If you had cash instead of the value of your Facebook shares, if you wouldn't use the cash to buy Facebook shares today (with the knowledge you now have), you should sell. The reason is that every day you hold it's the same thing as making the decision to buy. And at least you will have the benefit of Uncle Sam sharing in your loss.
Image courtesy of Flickr user Dru Bloomfield - At Home in Scottsdale
Study reveals more money may not make you happier - money.aol.co.uk
PA
Far from rejoicing when they get a pay rise, those on high salaries who are neurotic can easily view a raise as a failure. Neurotic people tend to enjoy income less if they are richer, the findings show. They chime with other studies that show wealth doesn't necessarily bring happiness.
In a working paper, economist Dr Eugenio Proto, from the Centre for Competitive Advantage in the Global Economy at the University of Warwick, looked at how personality traits can affect the way we feel about our income in terms of levels of life satisfaction.
He found evidence suggesting that neurotic people can view a pay rise or an increase in income as a failure if it is not as much as they expected.
Neuroticism is a tendency to experience negative emotional states. People with high levels of neuroticism have higher sensitivity to anger, hostility, or depression.
Dr Proto, who co-authored the paper with Aldo Rustichini from the University of Minnesota, said people who are on a high salary and have high levels of neuroticism are more likely to see a pay rise as a failure.
He said: "Someone who has high levels of neuroticism will see an income increase as a measure of success. When they are on a lower income, a pay increase does satisfy them because they see that as an achievement. However, if they are already on a higher income they may not think the pay increase is as much as they were expecting. So they see this as a partial failure and it lowers their life satisfaction."
This would explain why some bankers throw their toys out of the pram when they get their bonuses - while mere mortals like us have never had a bonus in their life.
Dr Proto added: "These results suggest that we see money more as a device to measure our successes or failures rather than as a means to achieve more comfort."
An older study showed that while the income per capita in the US between 1974 and 2004 almost doubled, the average level of happiness showed no appreciable trend upwards. This puzzling finding, called the Easterlin Paradox after its author, has been shown to hold also for European countries.
And a more recent UN report, which ranked countries according to levels of happiness, also suggested that money can't buy you happiness. The report identified the key factors to a nation's happiness as "a high degree of social equality, trust and quality of governance". Inequality is generally thought to damage societies. Scandinavian countries Denmark, Finland and Norway came top, while the UK barely scraped the top 20, coming in at number 18 below the United Arab Emirates and just above Venezuela.
Scottish independence: SNP denies financial plan U-turn - BBC News
The Scottish government has denied performing a policy U-turn by asking UK regulators to oversee Scots banks in an independent Scotland.
The opposition said the move came following the SNP's previous criticism of UK industry controls on Scotland.
But a spokesman for First Minister Alex Salmond said the policy had now simply been "defined".
Scottish Finance Secretary John Swinney laid out his position during a speech in Glasgow on Monday evening.
He underlined a plan to keep a "sterling zone" and the UK regulatory framework, if the Scottish electorate voted for independence in the referendum, expected to take place in autumn 2014.
Addressing a business audience, Mr Swinney said a sterling zone would provide businesses in Scotland and the rest of the UK with the "certainty and stability for trade, investment and growth".
He added: "As the Bank of England takes on the role of regulator for UK financial services - a very sensible and long overdue position - retaining the pound will preserve the highly integrated UK financial services market.
"That framework is solid and substantial and I know that understanding our proposal is important to many of you in making your decisions about Scotland's future."
This is difficult stuff for SNP ministers.
Their rhetoric about the financial crisis has been about failed regulation from London being more significant than the failings of bankers in Scotland.
And even if John Swinney thinks the coalition government's reforms are welcome, it still looks like regulation from London.
And from London, it looks a bit presumptions that a Scottish government can assume the protection of institutions based in London.
But the nationalist view is that the Bank of England, being a central bank for the whole of the United Kingdom, is not the creature of Whitehall or of the rest of the UK, but of Scotland as well.
Likewise, the pound sterling is "as much Scotland's currency as it is the currency of England and Wales".
SNP policy favours an independent Scotland joining the Euro, pending a referendum, but the current economic conditions means the option is not currently attractive.
Ministers also said the Bank of England would continue to oversee monetary policy and set interest rates, but an independent Scotland could have a seat on its Monetary Policy Committee, or have a role in appointments.
Labour said the SNP had previously talked about an independent Scotland having its own financial watchdog and had pledged "light-touch regulation".
Scottish Labour leader Johann Lamont, said: "The SNP are making this up as they go along.
"The bank regulators they blamed for the collapse of the banking system are now the people they want to be in charge of the banking system. They reject the UK but want to keep George Osborne in charge of the banks?
"The truth is they know the people of Scotland reject leaving the UK, so they are now performing contortions on policy to make leaving the UK seem like remaining in it."
When asked what the point of independence would be if the SNP favoured keeping the pound and subscribe to London-based financial regulation, the spokesman for Mr Salmond said there was a "fundamental distinction" between monetary policy and fiscal policy.
He explained: "What fiscal policy provides you with is the levers of economic power in order to boost economic growth and increase employment in Scotland.
"No Westminster government has control over interest rates and has not done so since 1997, so, in that sense, it would be exactly the same as for successive Westminster governments."
The spokesman said independence would provide Scotland with a "strong voice" in Europe, adding: "Independence is the only constitutional policy which can ensure that we have the ability to remove trident nuclear weapons from the river Clyde - devo max doesn't provide that power.
“Start Quote
End Quote Sir Howard DaviesI don't quite know how you can be a servant of two masters, in terms of two separate treasuries and one central bank”
"Independence is the only constitutional option which can ensure that Scotland decides which military activities we are involved in in order that never again can Scotland be dragged into an illegal war such as Iraq."
The comments came as Sir Howard Davies, a former head of the Financial Services Authority, told BBC Radio's Good Morning Scotland programme that the SNP position to keep a central Bank of England and the pound was unclear.
He said: "It's not obvious quite how a system with two separate finance ministries and one central bank would work.
"Supposing the Bank of England looked again at a Scottish bank and said, 'it's really in trouble, people would want it to be rescued, but we're not going to rescue it unless we're indemnified', where would they look for that indemnity?
"It wouldn't be the UK Treasury, presumably the English Treasury - it would have to be the Scottish Treasury.
"I don't quite know how you can be a servant of two masters, in terms of two separate treasuries and one central bank. I can't think of an analogy where that's the case."
The Scottish government said it supported a key recommendation of the Vickers report into banking reform to remove the taxpayer from having to bail out troubled institutions in future.
Responding to Sir Howard's point, Scotland's deputy first minister, Nicola Sturgeon, said in the event of a Scottish bailout being needed: "The Scottish government, in that scenario, would pay the Bank of England to provide lender of last resort facilities for Scottish banks.
"The Scottish government has made clear, the SNP's made clear, that an independent Scotland would remain within sterling."
A Treasury spokesman said the Scottish government's proposals remained "totally unclear".
The spokesman said: "If they are proposing a full monetary union with Sterling, then the Eurozone crisis shows that strong control of monetary policy, fiscal policy and borrowing would have to be agreed with the UK government and exercised centrally.
"This includes the role of the Bank of England and the conduct of macro-prudential regulation.
"If they are proposing an independent Scotland using the pound but without a formal monetary union, the presumption is that the Bank of England would not be required to act as lender of last resort or take account of the Scottish economy when setting monetary policy."
EU: movement of money, people can be limited - The Guardian
BRUSSELS (AP) — The European Commission has been providing legal advice to others who are considering possible scenarios should Greece leave the euro, a European Union spokesman said.
Olivier Bailly said Tuesday that, legally, limits could be imposed on movement of people and money across national borders within the EU if it's necessary to protect public order or public security — but not on economic grounds.
"Some people are working on scenarios," he said, but refused to confirm or identify which organizations and people were working on them.
Stocks rally in choppy trade, Spain yields see record - Reuters
NEW YORK |
NEW YORK (Reuters) - Stocks on world markets edged higher on low volumes on Tuesday, while Spanish bond yields rose to a euro-era high, as skepticism about a 100 billion euro bailout for that country's banks scared investors ahead of elections in Greece on Sunday.
Wall Street stocks were up also led by energy stocks as U.S. crude oil recovered some ground after Monday's slump.
"There's no real negative U.S. economic news and everything coming out of Europe we already know about," said Ken Polcari, managing director at ICAP Equities in New York. "Real asset managers are sitting tight, there's not much commitment and since there's not a lot of volume it's easy to push the market around," he said.
MSCI's world equity index .MIWD00000PUS rose 0.3 percent and the euro zone's blue-chip Euro STOXX 50 .STOXX50E index closed up 0.27 percent.
The Dow Jones industrial average .DJI was up 94.53 points, or 0.76 percent, to 12,505.76 at midday. The S&P 500 Index .SPX gained 7.78 points, or 0.59 percent, to 1,316.71. The Nasdaq Composite .IXIC added 19.38 points, or 0.69 percent, to 2,829.11.
Spanish government bond yields hit their highest since the euro was launched in 1999 on concern over how difficult it may be for Madrid to access debt markets in the longer term and as current holders of Spanish debt fear their claims for repayment will be subordinated to EU claims after the bank bailout.
Italian yields also rose as attention turned to the state of Rome's finances, with Austria's finance minister saying Italy may need a financial rescue because of its high borrowing costs. The statement drew a furious rebuke from the Italian prime minister.
Concerns that the Greek election on June 17 would bring to power parties opposed to its current bailout plan and force a disorderly exit from the euro zone were rekindled by a report that EU officials were considering ways to manage the fallout.
The euro was little changed for the day versus the greenback, around $1.2475, after a slump on Monday.
"Investors will likely continue to sell the euro into strength, especially with Greek elections on Sunday and a European Union summit next week, which should be heavy in headlines," said Camilla Sutton, chief currency strategist at Scotia Capital in Toronto. "Any euro rally should prove short-lived."
The growing impact of the euro zone crisis on the economic outlook was underlined by data showing a surprise fall in British manufacturing output in April.
Global growth concerns also pushed Brent crude oil prices down 1 percent to $97.03 a barrel. U.S. oil was up 0.3 percent at $82.97 a barrel after hitting a one-year low at $81.07.
(Reporting by Rodrigo Campos, Ryan Vlastelica and Julie Haviv, editing by Dave Zimmerman)
(This story has been corrected to fix the date of Greece elections to Sunday, not Saturday)
PNC Financial sees higher demand for mortgage buyback - Reuters
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