“Don’t know much about history. Don’t know much biology. Don’t know much about science books. Don’t know much about the French I took.” Sam Cooke. “Wonderful World.” 1958.
Unfortunately, things have changed much with students since we first heard that song in 1958. But, in the June Coaching Class we challenged our students to put their thinking caps on by posing the following question- “What, if by understanding the critical events in investing history, would make a difference between success or failure as an investor?” We got their attention.
Pop Quiz– So you just picked up your statement to review the bottom line. Apart from your interest in the change, do you understand how your account came to hold these positions? There is a very academic, scientific way it was developed– can you explain what it is?
In the Beginning– 1776. That’s the year Scottish economist and philosopher Adam Smith penned “The Wealth of Nations” advocating Free Markets (free trade and services encouraged by rather than interfered with by the government). Free Markets are the best way to provide value and wealth in a society. The flip side is Karl Marx, who believed that markets fail and therefore the economy for society must be centrally planned by the government.
Markets Work vs Markets Fail– So what does this have to do with my investments? Plenty! If you are a “free market” thinker then you understand that market prices are random, but correct– set by millions of pieces of information. Another way to view this is that shoppers “vote with their feet” and will always do what’s in their own best interest.
A modern-day example is retail. Why do shoppers select WalMart over Sears (or vice versa)? Prices and/or value. In a free market, prices will have to be adjusted in order for a company to remain competitive. If you are a “markets fail” thinker, then you try to legislate prices of goods and services to level the playing field– this is known as socialism. With price controls comes the collapse of fair and free competition, then the failure of companies “too big to fail” and the eventual take over by the government of private industrty (this is known as Communism).
Investing 101– The greatest early proponent of Marx’s philosophy of markets fail was Benjamin Graham who wrote “Securities Analysis” in 1934. He promoted stock picking and market timing. By carefully doing one’s homework, the investor could find these market failures in pricing and take advantage of them. Wall Street has been the greatest proponent of Graham’s strategies over the years despite the fact that he recanted in 1976 and sided with free market thinkers.
Back to the Classroom– Since Graham’s work was published many academics have completed valuable work supporting Adam Smith’s free market position. Dr Harry Markowitz was awarded the Nobel Prize for Economics based upon his work in 1952 that statistical, scientific diversification could offset risk and increase returns through Modern Portfolio Theory (MPT).
In 1964, Dr Bill Sharpe established the concept of measuring risk in the portfolio– a higher return requires a higher degree of risk. In 1965, Dr Paul Samuelson completed his important work that markets had unpredictable patterns, or are completely random– thereby defeating a whole industry strategy that one could predict and forecast earnings, prices of stock, sector rotations, etc. This was known as the Efficient Market Theory (EMT).
Professors Jensen and Beckenkamp tested free market assumptions in 1968 by asking the question “What if one bought the whole market (an index) rather than trying to pick the best stocks?” Their findings were brutal for the industry to hear that their brilliant portfolio managers continually proved they could not deliver market returns.
It Really is Rocket Science! In rounding out our “All Star Team” of academics are Professors Sinquefeld, Ibbotson, Fama and French. These gifts scholars had a hand in discovering where 90% of the market returns occur– a methodology they termed the “Three Factor Model.” The premise for the model is 1) Equities (stocks) out-perform fixed (bonds); 2) Small companies out-perform large companies; and 3) Value companies (book to market) out-perform growth companies.
Final Exam– Before we head for the lunchroom, let’s summarize a couple of important notes to help you get that perfect score on your financial SAT/ACT. First, recognize that the strategies used in your portfolio were not contrived by a bunch of self-servicing commercial Wall St types– but carefully based on the accomplishments of Nobel Laureates, nerds if you will, who’s methods carry academic integrity and who’s goal is to discover the truth.
Second, only use a mathematically sound approach. As my high school chemistry teacher was known to say “the true proof of science is verification by experiment” – the numbers don’t lie. Finally, you can have peace of mind knowing that with diversification in your portfolios, you will be getting all the available returns the market can offer– leaving no profit “on the table.” Class dismissed!
Philip W. Guske