Monday, March 22, 2010

Why Now Is Not The Time For Buy And Hold

The most common question I get from clients is, 'Is now a good time to invest in stocks?' What clients are really asking is, 'If I invest now, will stocks take me where I want to go, on my timeline?' Most advisors answer this question by referring to long-term average returns. Some reference the last 20 years, others the last 30 years, and a small few know average returns over the last 100 years or more. Advisors quote these average returns as though investors are actually likely to achieve this growth regardless of when they invest.

It Matters When You Invest

In reality, the timing of your decision to put your money to work in the stock market has an enormous impact on your likely future returns. For example, if you chose to invest your money in stocks in September of 1929, your portfolio would have achieved growth of -2.34% per year over the next decade. In contrast, if you invested in July of 1932, your portfolio would have grown at over 8% per year over the next 10 years. Investing in August 1972 would have shown investors -3% a year over the next decade, but putting your money to work exactly 10 years later would have netted an investor 10.6% per year after inflation!

Given that timing matters, one is left to wonder if there is something about those dates that would have given investors a clue about what to expect from stocks over the following 10 year period. It turns out that by analyzing Yale Professor Robert Shiller's publicly available database of stock market information going back to 1870, clear patterns emerge that can help investors set expectations about future returns. That's the good news. The bad news is that future returns from here are likely to leave buy and hold investors in the dust.

Are Markets Cheap or Expensive

Most investors are familiar with the commonly cited Price to Earnings Ratio, or PE ratio. This is simply the current price of a stock divided by its last year's earnings, and it is frequently to describe , very loosely, whether a stock is cheap or expensive. Interestingly, though the PE ratio is the most commonly cited statistic in finance, it provides very little useful information when picking stocks. A stock with a high PE may be growing very quickly in a market with little competition, high margins and high barriers to entry, so that the price is justified. Alternatively, a low PE stock may be lagging its competitors in terms of growth or profitability, and so the low price is justified.

The same ratio can be used to describe the stock market in aggregate. The market's PE ratio is just the current level of the index divided by the combined earnings of all its constituent companies. However, when analyzing the stock market in aggregate it makes sense to adjust the ratio by using stock market earnings over the past 10 years, adjusted for inflation, rather than just the previous year's earnings. This method was first proposed by Warren Buffet's mentor and value investment guru Benjamin Graham. He wanted a ratio that reflected the long-term trend of corporate earning potential in the economy, adjusted over one full business cycle. The Cyclically Adjusted PE, or CAPE, helps investors avoid the the misconception that markets are cheap just because the economy is at the peak in the current business cycle.

It turns out that, at the aggregate market level, the PE ratio does provide information that is useful to investors. Over time, investors are likely to receive above average returns by investing when markets are cheap (low PE), and below average returns by investing when markets are expensive (high PE). One can see from Chart 1. below that over the last 140 years, markets have traded in a PE range of about 5%(1921, 1932, 1982) through 45% (2000).

Chart 1.

Source: Robert Shiller

Do Cheap Markets Deliver Better Future Returns?

In Chart 2. below, one can clearly see the relationship between the PE of the market and future returns. Starting PE and future returns are inversely related, so low PE = high future returns and high PE = low future returns. In order to illustrate this relationship, I have inverted the PE ratio to show the market's earnings yield (10-year average earnings divided by current price), so the blue line on the following chart is the inverse of the blue line in Chart 1. When the market is expensive, the blue line in Chart 2. is closer to the bottom, not the top. The red line shows the returns to an investor who invested on each date over the subsequent 10-year period, after inflation and including dividends.

Chart 2.

Source: Robert Shiller, Butler|Philbrick & Associates

It is plain to the eye that the 10-year forward returns (red line) very closely track the market's long-term earnings yield ratio (red line). A cheap market (low PE, high earnings yield) usually results in high long-term returns, while an expensive market (high PE, low earnings yield), usually results in low long-term returns.

It is worth noting at this point that the predictive value of the CAPE ratio is less robust when markets are neither very cheap nor very expensive. For the purpose of the analysis below, we assume the market is cheap when it trades in the 1st quartile of all CAPE ratios over the 140 year time period; it is expensive when it trades in the 4th quartile. When the market is priced in the 2nd or 3rd quartiles, it is neither cheap nor expensive.

Chart 3. is a scatter plot of all monthly CAPE ratios and the corresponding future 10-year returns, for all months where the market is either cheap (1st quartile), or expensive (4th quartile). The chart also shows the best fit line for the plot, as well as the least-squares linear approximation formula and R-square value. I then calculated the model's expected future returns from the formula using the current market CAPE ratio (20.63). An R-square value above 0.5 suggests a very strong relationship, so the market's current CAPE ratio does an excellent job of explaining future returns.

Chart 3.

Source: Robert Shiller, Butler|Philbrick & Associates

Chart 4. attempts to illustrate the relationship between the market's CAPE ratio and future returns by showing the distributions of future returns for both cheap (1st quartile CAPE) and expensive (4th quartile CAPE) markets. You can see that the median 10-year real return to stocks when markets are cheap is 9% per year, while the return to stocks when markets are expensive is 3% per year. Chart 3. shows that the modeled return to stocks when markets are priced at a CAPE of 20.63 is approximately 3.8% per year.

Chart 4.

Source: Robert Shiller, Butler|Philbrick & Associates

Lower Expectations or Pursue Alternatives to Buy and Hold

Many advisors will argue that a 3.8% expected return may be poor, but it is much better than what an investor can expect from bonds or cash. On this basis, an investor should allocate a larger portion of his or her portfolio to stocks. While this logic may be sound if several other conditions are met, it is peripheral to the main conclusion of this analysis. The primary take-away is that investors should set lower expectations for future returns from here, and build these lower returns into financial and retirement planning models. While most planning software uses future nominal returns of 8% per year (every year!), investors are unlikely to see these returns in practice, especially after fees.

Alternatively, accredited investors may wish to pursue alternative strategies that have demonstrated an ability to deliver robust real returns in good markets and bad. I will spend more time on these strategies going forward, but for an excellent example, look no further than last week's post.

Monday, March 15, 2010

A Cure for Investor Depression

The previous post hinted at a future piece on systematic trading. In this author's humble opinion, well tested systematic investment strategies are the antidote to the poison of expert predictions. These strategies embrace the probabilistic nature of investment markets by applying hard and fast rules for investment decisions based on actual empirical evidence. In other words, these systems do not rely on an elegant theory that is not supported by actual data (like Modern Portfolio Theory, CAPM, or the Efficient Markets Hypothesis), or on the confident views of market experts, but instead rely on rigorously tested systems developed from mountains of actual data. 

These systems demonstrate an ability to do well in bad and good markets across securities, asset classes, geographies, and time frames. But don't take it from me. Take it from one of the most experienced and successful systematic trading teams in Canada, Jason Russel and Nicholas Markos at Acorn Global Investments. See their recent paper below.

Acorn Investments - Systematic Trading

For more information about systematic trading or Acorn's systems, go to their home on the Web.

And What About Financial Experts?

As this blog purports to focus on topics relevant to investing, not just behavioral psychology, I will present some evidence that investment strategists, economists and analysts are particularly awful at predicting the future for the economy, stock prices, earnings, or any other series relevant to investor success. Further, these financial prognosticators are vastly overconfident and resistant to data that runs counter to their views.

Before presenting the ugly details, I want to emphasize that investors should not feel disheartened by the evidence that financial marketing and media is dominated by loud, overconfident shills and mountebanks. On the contrary, investors should feel liberated to pursue other interests rather than reading or watching business news. For those that enjoy the cognitive 'sport' of investing from the standpoint of strategy and game theory, feel free to explore the various scenarios with your colleagues and friends as fun dinner conversation. Just don't orient your portfolio on the basis of your conclusions, or the conclusions of other thinkers. You are all bound to be wrong far more often than you are right.

Now, here is the evidence. These charts are sourced from James Montier's book Behavioural Investing (2007):

Chart 1. Consensus bond yields forecasts 1 year out vs. actual

Chart 2. Consensus S&P500 level 1 year forecasts vs. actual

Chart 3. Consensus S&P500 aggregate earnings 1 year forecasts vs. actual

Note that in all cases, strategists, analysts and economists do an excellent job of describing what happened or is currently happening, that is they do an excellent job of observing the obvious. Unfortunately, they demonstrate no predictive ability whatsoever, as their forecast series for likely levels one year out appear to be lagging indicators, not leading ones.


Still not convinced? The following chart shows the percentage error of analyst earnings forecasts from 24  months prior to an earnings announcement through to the date of the announcement, using data from 1986 - 2000. Not surprisingly, analysts demonstrate significant over-optimism in their earnings forecasts from two years out, while their forecasts narrow toward the actual number by around 2 months prior to earnings. The average error at 1 year is approximately 10%, and by a month prior they are slightly pessimistic. Of course this slight pessimism then allows the companies they cover to beat estimates slightly, which often results in a price jump.

Chart 4. The walk down to beatable earnings.
Source: Dresdner Kleinwort Wasserstein Macro Research

The error rate would not be so worrisome if it weren't for the high level of confidence that investment professionals imbue on their predictions. This effect is perhaps best illustrated using the results of a study by Torngern and Montgomery (2004). The study set laypeople (psychology undergraduates, the perennial guinea pigs) against investment professionals in a competition to select the stock that they thought would outperform over the next month from pairs of stocks. All the stocks were well known companies, but participants were given information such as the industry and prior 12-month performance for each stock as well. Participants were asked to choose the best performer from the pair, and to provide their level of confidence in their choice.

Over many picks, one might hope that when participants were 50% confident that their choice was right, they were accurate about half the time, and when they were 90% confident they were right almost all the time. In fact, as you can see from the chart below, a person's confidence level was largely irrelevant to their accuracy over time. In other words, having greater confidence in a choice did not lead to higher accuracy levels. In fact, at extreme levels of confidence (>80%), professionals were actually less likely to get it right. At a 90% level of confidence, professional investors actually got it right only 15% of the time, while at a 55% - 75% level of confidence they achieved about 40% accuracy.

Chart 4: Accuracy and confidence on a stock selection task
Source: Torngren and Montgomery (2004)

It is important to remember that over a 1-month time horizon the results of these stock choices are almost random, so we are not out to skewer professionals on the basis of their accuracy in this test. Instead, we are left to wonder why anyone expressed such high levels of confidence in their choices. When asked this question, laypeople admitted that they were mostly guessing, but also placed some emphasis on the previous month's returns. In contrast, almost no professionals admitted to guessing; instead, they attributed their choices to 'Other knowledge' about the stocks, and 'Intuition'. Incidentally, the only factor with any predictive power in this example, however small, is the previous month's results. It has been well demonstrated that there is a strong mean-reversion tendency in stocks over a 1 month time frame, so participants may have had a slight advantage if they chose stocks with poor previous 1 month returns to outperform over the next month.

Chart 5. Average rating of decision input importance
Source: Torngren and Montgomery (2004)

The quantum leap in thinking that I want to convey with this post is that there is indisputable empirical evidence that the world is too complex to enable accurate forecasting. Axiomatically, people should consider expert forecasts as no more than entertaining narratives - brain candy to stimulate the imagination. Even complex mathematical models are relatively poor predictors of the future beyond a certain time threshold. The best we can hope for is an assessment that a dynamic or trend is likely to stay on a certain course, or alternatively that the course is changing. Forecasting the direction or the magnitude of the change in trend is empirically impossible. We will be spending much more time on trend-following strategies going forward.

Friday, March 12, 2010

Beware of Confident Experts Bearing Forecasts

Among all forms of mistake, prophecy is the most gratuitous. – GEORGE ELIOT

We have spent a great deal of time offering evidence that experts are poor predictors of the future. This post will describe the results of the most comprehensive and compelling study of expert fallibility to date, and offer lessons from the study that we can use to make better use (or not!) of expert opinions in future decisions.

Of course, we – the consumers of expert pronouncements – will continue to be in thrall to experts for the same reasons that our ancestors submitted to shamans and oracles: our uncontrollable need to believe in a controllable world and our flawed understanding of the laws of chance. We generally lack the willpower and good sense to resist the snake oil products on offer. Who wants to believe that, on the big questions, we could do as well tossing a coin as by consulting accredited experts.

Philip Tetlock spent over 20 years asking some of the top experts in their fields to make predictions about the future. The idea for the experiment took shape in the two or three year period prior to 1984 during the early years of the Reagan administration. Many of you will recall that this was a time of great anxiety and tension as the Soviets and the Americans seemed to move closer to nuclear Armageddon each day. Tetlock served on a committee charged with observing and forming opinions on American/Soviet relations. At that time in late 1983 the Bulletin of Nuclear Scientists had moved their Doomsday clock closer to midnight than at any other time since the Cuban Missile Crisis. It was widely believed by liberals that Reagan was leading the country on the road to nuclear apocalypse. Conservatives meanwhile believed that the best realistic outcome was for it to adopt a neo-Stalinist mode and retreat. Generally, the dominant view on both sides of the political aisle was that nothing good was going to happen.

While on this committee, which consisted of many well known political and military strategists at the time, it was widely noted that Gorbachev was rising through the political ranks in the Kremlin. Tetlock observed that no one at the time, however, believed that Gorbachev was likely to assume a leadership role in the Politboro. Further, it was commonly held that Gorbachev was secretly a neo-Stalinist in disguise. No one of any credibility thought that Gorbachev would execute a liberal revolution which would lead to the dissolution of the Soviet Union, and eventually the collapse of the Berlin wall and the reunification of Germany.

Of course, that’s just what Gorbachev went on to do. Interestingly, once Gorbachev had executed his coup, strategists of all stripes were eager to claim credit for having predicted just this outcome. Tetlock knew that in fact no one had predicted this outcome. This convinced Tetlock that there really would be great value if someone tried systematically to keep score on political experts. And that is just what he proceeded to do. From 1984 through 2001 Tetlock solicited frequent predictions from 284 experts in international affairs, economics, political strategy, and other complex fields. The experts consisted of a mixture of academics, journalists, intelligence analysts and people in various think-tanks, with an average of roughly 12 years of work experience each. No political view was over or underrepresented. Each expert made approximately 100 predictions, resulting in about 28,000 predictions in total. This allowed Tetlock to put the law of large numbers to good use. Experts were asked to make predictions on such topics as economic growth, inflation, unemployment, policy priorities, defense spending, leadership changes, border conflicts, entry-exit from international agreements, etc.

The results from the study are broad reaching and complex. Generally the results support the view that it is the way one thinks, not the depth of knowledge about a certain topic or theory, which matters most in tests of complex prediction. Tetlock expounds on the spectrum of cognitive reasoning techniques bounded by foxes at one end of the spectrum and hedgehogs on the other. (Un)fortunately, this distinction is beyond the scope of this essay. We are more interested specifically in how well experts delivered accurate predictions over time, especially as it relates to experts’ confidence in their own predictions.
Here is a summary of the important lessons from the study:
  1. Experts are no better at predicting the future than the rest of us. In fact they are less accurate than a large group of dart-throwing monkeys
  2. Experts (like everyone else) are unlikely to admit when they are wrong, or to revise their beliefs in the face of conflicting evidence
  3. Those who know a lot about a subject are more likely to predict extreme outcomes (which rarely happen), and are more overconfident in their forecasts
  4. Specialists are no more reliable than non-specialists in forecasting outcomes in their own domain of study
  5. Experts who hedge their views, are self critical and consider alternative outcomes are more likely to be right
  6. Those experts who are better known and more frequently quoted are less likely to be right. Frightfully, these experts also make entertaining media guests
  7. Experts are no better at forecasting than basic trend-following systems such as ‘no change’ or ‘continue with the same rate of change’
  8. Of the 284 experts who offered predictions over 18 years, not one expert demonstrated a superior forecasting ability
In a review of Tetlock’s book, Louise Menand at The New Yorker magazine tells how Tetlock witnessed a shocking experiment during his student days at Yale. According to Tetlock,
“A rat was placed in a T-shaped maze. Food was placed in either the right or the left transept of the T in a random sequence such that, over the long run, the food was on the left sixty per cent of the time and on the right forty per cent. Neither the students nor (needless to say) the rat was told these frequencies. The students were asked to predict on which side of the T the food would appear each time. The rat eventually figured out that the food was on the left side more often than the right, and it therefore nearly always went to the left, scoring roughly sixty per cent—D, but a passing grade. The students looked for patterns of left-right placement, and ended up scoring only fifty-two per cent, an F. The rat, having no reputation to begin with, was not embarrassed about being wrong two out of every five tries. But Yale students, who do have reputations, searched for a hidden order in the sequence. They couldn’t deal with forty-per-cent error, so they ended up with almost fifty-per-cent error.”
Amos Tversky, the eminent behavioral economist, was fond of saying that human beings can only distinguish between three probabilistic outcomes: something is sure to happen; something is sure not to happen; and maybe. Quantitative economists and other forecasters can likely distinguish probabilities at a much higher level of granularity, but the experts that subscribe to these models are likely susceptible to the same overconfidence, and are thus not particularly reliable. The reality is that we live in a probabilistic world, not a deterministic one. On this basis, a decision making style that is predicated on adaptation rather than forecasting makes the most sense. Endeavour to not mistake a compelling narrative about future events with a strong likelihood of accuracy. In fact, one would do well to ignore loud exponents of fancy theories altogther, especially where those theories are used to make confident forecasts. By making many smaller bets with less confidence rather than few large bets with great confidence, you are likely to meet with greater success over time. 

For more information on Tetlock’s study and his results, I urge you to watch a presentation of his results at this link:

Also, the full New Yorker article is worth reading. You will find it at

Purchase Philip Tetlock’s book at Amazon.

Sunday, February 7, 2010

An Interlude to Discuss Education

"We must wake up to what our schools really are: laboratories of experimentation on young minds, drill centers for the habits and attitudes that corporate society demands. Mandatory education serves children only incidentally; its real purpose is to turn them into servants." John Taylor Gatto

Your humble blogger had an opportunity to teach math and science to middle-school children in Asia during a two year stay in Bangkok. Though I had as much experience with the education system as any western person, having spent 11 years of my life in Canadian public schools (and one year in a private school for university prep), I had no formal training in education. Further, and with the benefit of hindsight, I have no particular talent for teaching. Truly effective teaching, like most skills, can be refined in school and through practice, but requires a certain predisposition and talent to achieve anything greater than mediocrity. I believe that no amount of training or practice would enable me to become anything but a passable teacher.

Like most people, I had not given much thought to pedagogical practice or philosophy before my teaching stint. Of course, any thoughtful person thrown into an established discipline will rail against the rules initially, and I was no exception. It took me 5 or 6 weeks to accept my limitations and the limitations of the rules and philosophy of my Bangkok school. Once I overcame these hurdles I enjoyed the process of knowledge transfer, and the mostly constructive interaction with the children. 

Of course, true teaching encompasses far more than this, but in my two years at the school I never managed to evolve my skills to inspire, or to coach, and I had a limited ability to alter my lessons to address the various learning styles of the children in my classes. As a visio-auditory learner, I focused on theory and abstraction at the expense of labs and tactile activities. In contrast, gifted teachers are able to project themselves and their material into all major learning domains at once, effortlessly and instinctively. Such gifted masters can encourage, inspire, coach and support even the most corrupted and stubborn of souls.

In Canada, due mostly to the destructive propaganda disseminated by almost every political party at all levels of government, the teaching profession is afflicted with a generalized public disdain. Politicians have transmogrified the otherwise constructive ideal of accountability in our school system into a twisted flail with which the teaching profession is consistently flogged. Naturally, parents have adopted this attitude toward teachers, and many parents serve as primary obstacles to teacher efficacy nationwide. Parents' attitudes are, of course, adopted by their children, and so modern Canadian classrooms are characterized by disrespect, disdain, and often, due to the way information and emotion is twisted in the tortured minds of adolescents, aggression.

At the same time, courts and school boards have severely limited the tools teachers can use to discipline and motivate. I am not advocating a return to corporeal punishment. However, students should at the very least be taught the basic relationship between action and consequence. Instead, current rules prohibit teachers from penalizing students handing in assignments late. In fact, teachers are required to grade high-school assignments without penalty if they are handed in at any time prior to the end of the academic year. It seems unfair to students to teach them that they are not accountable to deliver on a timetable.

The sorry state of education in the west today is all the more distressing when compared with the caliber of students being produced by cultures from the emerging world. It is important to acknowledge the powerful family and cultural drivers, especially in Asia, that reinforce the education focus. Asian families often live with several generations in one household. Each person in each generation has a role, with younger generations supporting elder generations financially, and grandparents helping with homemaking, cooking and childcare. Many families sacrifice substantially to ensure their children have access to quality education, and school-aged children feel the weight of this responsibility. 

This tradition crosses geographic boundaries, so children from these cultures tend to be high achievers no matter where they attend school. It was instructive, if anecdotal, to observe an announcement in a newspaper from a small Detroit exurb featuring the pictures of the top 50 academic achievers from local high-schools. Of the 50 pictures featured, fully 38 were of Asian descent with the balance a mix of caucasian, Latin and African. Note that the exurb in question was typical of Detroit. In other words, the ratio of Asians in the population was relatively low.

My children, aged two and 4, take Mandarin lessons every Saturday morning. When asked why, I joke that I want my children to at least qualify to be nannies or gardeners for Asian families. If I really wanted to give them an advantage, I would move to Singapore and force them to compete in the Asian school system. I would also teach them Hindi, but we haven't discovered any readily accessible Hindi schools in our city. Of course, it's just a matter of time.

A few months into my teaching experience, I was fortunate enough to come across an article in Harper's Magazine written by an inspired ex-teacher, John Taylor Gatto. I've included this article in its entirety. It is long but dense with frank talk about schools and teaching from an experienced teacher with an urgent desire to revolutionize western education, and a plan for how to do it.
AGAINST SCHOOL: How public education cripples our kids, and why.
By John Taylor Gatto
 John Taylor Gatto is a former New York State and New York City Teacher of the Year and the author, most recently, of The Underground History of American Education. He was a participant in the Harper's Magazine forum "School on a Hill," which appeared in the September 2001 issue.
 I taught for thirty years in some of the worst schools in Manhattan, and in some of the best, and during that time I became an expert in boredom. Boredom was everywhere in my world, and if you asked the kids, as I often did, why they felt so bored, they always gave the same answers: They said the work was stupid, that it made no sense, that they already knew it. They said they wanted to be doing something real, not just sitting around. They said teachers didn't seem to know much about their subjects and clearly weren't interested in learning more. And the kids were right: their teachers were every bit as bored as they were. 
 Boredom is the common condition of schoolteachers, and anyone who has spent time in a teachers' lounge can vouch for the low energy, the whining, the dispirited attitudes, to be found there. When asked why they feel bored, the teachers tend to blame the kids, as you might expect. Who wouldn't get bored teaching students who are rude and interested only in grades? If even that. Of course, teachers are themselves products of the same twelve-year compulsory school programs that so thoroughly bore their students, and as school personnel they are trapped inside structures even more rigid than those imposed upon the children. Who, then, is to blame? 
 We all are. My grandfather taught me that. One afternoon when I was seven I complained to him of boredom, and he batted me hard on the head. He told me that I was never to use that term in his presence again, that if I was bored it was my fault and no one else's. The obligation to amuse and instruct myself was entirely my own, and people who didn't know that were childish people, to be avoided if possible. Certainly not to be trusted. That episode cured me of boredom forever, and here and there over the years I was able to pass on the lesson to some remarkable student. For the most part, however, I found it futile to challenge the official notion that boredom and childishness were the natural state of affairs in the classroom. Often I had to defy custom, and even bend the law, to help kids break out of this trap. 
 The empire struck back, of course; childish adults regularly conflate opposition with disloyalty. I once returned from a medical leave to discover that all evidence of my having been granted the leave had been purposely destroyed, that my job had been terminated, and that I no longer possessed even a teaching license. After nine months of tormented effort I was able to retrieve the license when a school secretary testified to witnessing the plot unfold. In the meantime my family suffered more than I care to remember. By the time I finally retired in 1991, 1 had more than enough reason to think of our schools--with their long-term, cell-block-style, forced confinement of both students and teachers--as virtual factories of childishness. Yet I honestly could not see why they had to be that way. My own experience had revealed to me what many other teachers must learn along the way, too, yet keep to themselves for fear of reprisal: if we wanted to we could easily and inexpensively jettison the old, stupid structures and help kids take an education rather than merely receive a schooling. We could encourage the best qualities of youthfulness--curiosity, adventure, resilience, the capacity for surprising insight--simply by being more flexible about time, texts, and tests, by introducing kids to truly competent adults, and by giving each student what autonomy he or she needs in order to take a risk every now and then. 
 But we don't do that. And the more I asked why not, and persisted in thinking about the "problem" of schooling as an engineer might, the more I missed the point: What if there is no "problem" with our schools? What if they are the way they are, so expensively flying in the face of common sense and long experience in how children learn things, not because they are doing something wrong but because they are doing something right? Is it possible that George W. Bush accidentally spoke the truth when he said we would "leave no child behind"? Could it be that our schools are designed to make sure not one of them ever really grows up? 
 Do we really need school? I don't mean education, just forced schooling: six classes a day, five days a week, nine months a year, for twelve years. Is this deadly routine really necessary? And if so, for what? Don't hide behind reading, writing, and arithmetic as a rationale, because 2 million happy homeschoolers have surely put that banal justification to rest. Even if they hadn't, a considerable number of well-known Americans never went through the twelve-year wringer our kids currently go through, and they turned out all right. George Washington, Benjamin Franklin, Thomas Jefferson, Abraham Lincoln? Someone taught them, to be sure, but they were not products of a school system, and not one of them was ever "graduated" from a secondary school. Throughout most of American history, kids generally didn't go to high school, yet the unschooled rose to be admirals, like Farragut; inventors, like Edison; captains of industry, like Carnegie and Rockefeller; writers, like Melville and Twain and Conrad; and even scholars, like Margaret Mead. In fact, until pretty recently people who reached the age of thirteen weren't looked upon as children at all. Ariel Durant, who co-wrote an enormous, and very good, multivolume history of the world with her husband, Will, was happily married at fifteen, and who could reasonably claim that Ariel Durant was an uneducated person? Unschooled, perhaps, but not uneducated. 
 We have been taught (that is, schooled) in this country to think of "success" as synonymous with, or at least dependent upon, "schooling," but historically that isn't true in either an intellectual or a financial sense. And plenty of people throughout the world today find a way to educate themselves without resorting to a system of compulsory secondary schools that all too often resemble prisons. Why, then, do Americans confuse education with just such a system? What exactly is the purpose of our public schools? 
 Mass schooling of a compulsory nature really got its teeth into the United States between 1905 and 1915, though it was conceived of much earlier and pushed for throughout most of the nineteenth century. The reason given for this enormous upheaval of family life and cultural traditions was, roughly speaking, threefold: 
 1) To make good people. 
2) To make good citizens. 
3) To make each person his or her personal best. 
These goals are still trotted out today on a regular basis, and most of us accept them in one form or another as a decent definition of public education's mission, however short schools actually fall in achieving them. But we are dead wrong. Compounding our error is the fact that the national literature holds numerous and surprisingly consistent statements of compulsory schooling's true purpose. We have, for example, the great H. L. Mencken, who wrote in The American Mercury for April 1924 that the aim of public education is not 
 to fill the young of the species with knowledge and awaken their intelligence. ... Nothing could be further from the truth. The aim ... is simply to reduce as many individuals as possible to the same safe level, to breed and train a standardized citizenry, to put down dissent and originality. That is its aim in the United States... and that is its aim everywhere else. 
 Because of Mencken's reputation as a satirist, we might be tempted to dismiss this passage as a bit of hyperbolic sarcasm. His article, however, goes on to trace the template for our own educational system back to the now vanished, though never to be forgotten, military state of Prussia. And although he was certainly aware of the irony that we had recently been at war with Germany, the heir to Prussian thought and culture, Mencken was being perfectly serious here. Our educational system really is Prussian in origin, and that really is cause for concern. 
 The odd fact of a Prussian provenance for our schools pops up again and again once you know to look for it. William James alluded to it many times at the turn of the century. Orestes Brownson, the hero of Christopher Lasch's 1991 book, The True and Only Heaven, was publicly denouncing the Prussianization of American schools back in the 1840s. Horace Mann's "Seventh Annual Report" to the Massachusetts State Board of Education in 1843 is essentially a paean to the land of Frederick the Great and a call for its schooling to be brought here. That Prussian culture loomed large in America is hardly surprising, given our early association with that utopian state. A Prussian served as Washington's aide during the Revolutionary War, and so many German-speaking people had settled here by 1795 that Congress considered publishing a German-language edition of the federal laws. But what shocks is that we should so eagerly have adopted one of the very worst aspects of Prussian culture: an educational system deliberately designed to produce mediocre intellects, to hamstring the inner life, to deny students appreciable leadership skills, and to ensure docile and incomplete citizens in order to render the populace "manageable." 
 It was from James Bryant Conant--president of Harvard for twenty years, WWI poison-gas specialist, WWII executive on the atomic-bomb project, high commissioner of the American zone in Germany after WWII, and truly one of the most influential figures of the twentieth century--that I first got wind of the real purposes of American schooling. Without Conant, we would probably not have the same style and degree of standardized testing that we enjoy today, nor would we be blessed with gargantuan high schools that warehouse 2,000 to 4,000 students at a time, like the famous Columbine High in Littleton, Colorado. Shortly after I retired from teaching I picked up Conant's 1959 book-length essay, The Child, the Parent and the State, and was more than a little intrigued to see him mention in passing that the modem schools we attend were the result of a "revolution" engineered between 1905 and 1930. A revolution? He declines to elaborate, but he does direct the curious and the uninformed to Alexander Inglis's 1918 book, Principles of Secondary Education, in which "one saw this revolution through the eyes of a revolutionary." 
 Inglis, for whom a lecture in education at Harvard is named, makes it perfectly clear that compulsory schooling on this continent was intended to be just what it had been for Prussia in the 1820s: a fifth column into the burgeoning democratic movement that threatened to give the peasants and the proletarians a voice at the bargaining table. Modern, industrialized, compulsory schooling was to make a sort of surgical incision into the prospective unity of these underclasses. Divide children by subject, by age-grading, by constant rankings on tests, and by many other more subtle means, and it was unlikely that the ignorant mass of mankind, separated in childhood, would ever re-integrate into a dangerous whole. 
 Inglis breaks down the purpose--the actual purpose--of modem schooling into six basic functions, any one of which is enough to curl the hair of those innocent enough to believe the three traditional goals listed earlier: 
 1) The adjustive or adaptive function. Schools are to establish fixed habits of reaction to authority. This, of course, precludes critical judgment completely. It also pretty much destroys the idea that useful or interesting material should be taught, because you can't test for reflexive obedience until you know whether you can make kids learn, and do, foolish and boring things. 
2) The integrating function. This might well be called "the conformity function," because its intention is to make children as alike as possible. People who conform are predictable, and this is of great use to those who wish to harness and manipulate a large labor force. 
3) The diagnostic and directive function. School is meant to determine each student's proper social role. This is done by logging evidence mathematically and anecdotally on cumulative records. As in "your permanent record." Yes, you do have one. 
4) The differentiating function. Once their social role has been "diagnosed," children are to be sorted by role and trained only so far as their destination in the social machine merits--and not one step further. So much for making kids their personal best. 
5) The selective function. This refers not to human choice at all but to Darwin's theory of natural selection as applied to what he called "the favored races." In short, the idea is to help things along by consciously attempting to improve the breeding stock. Schools are meant to tag the unfit--with poor grades, remedial placement, and other punishments--clearly enough that their peers will accept them as inferior and effectively bar them from the reproductive sweepstakes. That's what all those little humiliations from first grade onward were intended to do: wash the dirt down the drain. 
6) The propaedeutic function. The societal system implied by these rules will require an elite group of caretakers. To that end, a small fraction of the kids will quietly be taught how to manage this continuing project, how to watch over and control a population deliberately dumbed down and declawed in order that government might proceed unchallenged and corporations might never want for obedient labor. 
 That, unfortunately, is the purpose of mandatory public education in this country. And lest you take Inglis for an isolated crank with a rather too cynical take on the educational enterprise, you should know that he was hardly alone in championing these ideas. Conant himself, building on the ideas of Horace Mann and others, campaigned tirelessly for an American school system designed along the same lines. Men like George Peabody, who funded the cause of mandatory schooling throughout the South, surely understood that the Prussian system was useful in creating not only a harmless electorate and a servile labor force but also a virtual herd of mindless consumers. In time a great number of industrial titans came to recognize the enormous profits to be had by cultivating and tending just such a herd via public education, among them Andrew Carnegie and John D. Rockefeller. 
 There you have it. Now you know. We don't need Karl Marx's conception of a grand warfare between the classes to see that it is in the interest of complex management, economic or political, to dumb people down, to demoralize them, to divide them from one another, and to discard them if they don't conform. Class may frame the proposition, as when Woodrow Wilson, then president of Princeton University, said the following to the New York City School Teachers Association in 1909: "We want one class of persons to have a liberal education, and we want another class of persons, a very much larger class, of necessity, in every society, to forgo the privileges of a liberal education and fit themselves to perform specific difficult manual tasks." But the motives behind the disgusting decisions that bring about these ends need not be class-based at all. They can stem purely from fear, or from the by now familiar belief that "efficiency" is the paramount virtue, rather than love, liberty, laughter, or hope. Above all, they can stem from simple greed. 
 There were vast fortunes to be made, after all, in an economy based on mass production and organized to favor the large corporation rather than the small business or the family farm. But mass production required mass consumption, and at the turn of the twentieth century most Americans considered it both unnatural and unwise to buy things they didn't actually need. Mandatory schooling was a godsend on that count. School didn't have to train kids in any direct sense to think they should consume nonstop, because it did something even better: it encouraged them not to think at all. And that left them sitting ducks for another great invention of the modem era--marketing. 
 Now, you needn't have studied marketing to know that there are two groups of people who can always be convinced to consume more than they need to: addicts and children. School has done a pretty good job of turning our children into addicts, but it has done a spectacular job of turning our children into children. Again, this is no accident. Theorists from Plato to Rousseau to our own Dr. Inglis knew that if children could be cloistered with other children, stripped of responsibility and independence, encouraged to develop only the trivializing emotions of greed, envy, jealousy, and fear, they would grow older but never truly grow up. In the 1934 edition of his once well-known book Public Education in the United States, Ellwood P. Cubberley detailed and praised the way the strategy of successive school enlargements had extended childhood by two to six years, and forced schooling was at that point still quite new. This same Cubberley--who was dean of Stanford's School of Education, a textbook editor at Houghton Mifflin, and Conant's friend and correspondent at Harvard--had written the following in the 1922 edition of his book Public School Administration: "Our schools are ... factories in which the raw products (children) are to be shaped and fashioned .... And it is the business of the school to build its pupils according to the specifications laid down." 
 It's perfectly obvious from our society today what those specifications were. Maturity has by now been banished from nearly every aspect of our lives. Easy divorce laws have removed the need to work at relationships; easy credit has removed the need for fiscal self-control; easy entertainment has removed the need to learn to entertain oneself; easy answers have removed the need to ask questions. We have become a nation of children, happy to surrender our judgments and our wills to political exhortations and commercial blandishments that would insult actual adults. We buy televisions, and then we buy the things we see on the television. We buy computers, and then we buy the things we see on the computer. We buy $150 sneakers whether we need them or not, and when they fall apart too soon we buy another pair. We drive SUVs and believe the lie that they constitute a kind of life insurance, even when we're upside-down in them. And, worst of all, we don't bat an eye when Ari Fleischer tells us to "be careful what you say," even if we remember having been told somewhere back in school that America is the land of the free. We simply buy that one too. Our schooling, as intended, has seen to it. 
Now for the good news. Once you understand the logic behind modern schooling, its tricks and traps are fairly easy to avoid. School trains children to be employees and consumers; teach your own to be leaders and adventurers. School trains children to obey reflexively; teach your own to think critically and independently. Well-schooled kids have a low threshold for boredom; help your own to develop an inner life so that they'll never be bored. Urge them to take on the serious material, the grown-up material, in history, literature, philosophy, music, art, economics, theology--all the stuff schoolteachers know well enough to avoid. Challenge your kids with plenty of solitude so that they can learn to enjoy their own company, to conduct inner dialogues. Well-schooled people are conditioned to dread being alone, and they seek constant companionship through the TV, the computer, the cell phone, and through shallow friendships quickly acquired and quickly abandoned. Your children should have a more meaningful life, and they can. 
First, though, we must wake up to what our schools really are: laboratories of experimentation on young minds, drill centers for the habits and attitudes that corporate society demands. Mandatory education serves children only incidentally; its real purpose is to turn them into servants. Don't let your own have their childhoods extended, not even for a day. If David Farragut could take command of a captured British warship as a pre-teen, if Thomas Edison could publish a broadsheet at the age of twelve, if Ben Franklin could apprentice himself to a printer at the same age (then put himself through a course of study that would choke a Yale senior today), there's no telling what your own kids could do. After a long life, and thirty years in the public school trenches, I've concluded that genius is as common as dirt. We suppress our genius only because we haven't yet figured out how to manage a population of educated men and women. The solution, I think, is simple and glorious. Let them manage themselves. 

Tuesday, January 26, 2010

On Market Timing

It is a common refrain from mutual fund and investment management marketing material that investors should assume that it is impossible to time the market. In reality, with a fairly simple toolbox small investors can take steps to largely avoid major bear markets while enjoying the bulk of large, multi-year bull markets.
One might wonder, if this is possible, why everyone does not follow such a system. There is a different answer to this question for each major type of investor.
Large investors like pension funds, mutual funds and institutional portfolio managers can not react quickly enough to take advantage of the signals. It takes several weeks, often months, for very large investors to enter and exit stock and bond positions. A rapid exit would have a dramatic effect on the stocks being purchased or sold, and in the case of very large investors, on the markets themselves. For these investors, ‘Buy and Hold’ is the only option, so this is the message they preach in their marketing materials. Further, investors who can not sell do not invest in the development of market timing strategies.
Small investors who own stocks or mutual funds often deal with an Advisor with a large number of clients. Under regulations in Canada and the U.S., most Advisors must call each client for approval to buy or sell securities in their portfolios. An average Advisor with 200 clients to call may take a week or more to contact everybody. Often, these Advisors choose not to act rather than undertake the Herculean effort to reorient their clients’ accounts for changing market conditions. Further, market timing signals usually require quick action. As these Advisors can not act quickly to reallocate all their clients’ funds, they do not invest in the development of market timing systems.

Source: Butler|Philbrick & Associates
Click for larger version.

A small proportion of Advisors are licensed to make changes to all their clients’ portfolios at once without having to call. These Advisors usually have special qualifications, such as a CFA or a CIM, and significant experience such that regulators grant them permission to manage client portfolios with discretion. In Canada, professionals who service individual clients, and who possess a discretionary license, are designated Associate Portfolio Managers or Portfolio Managers. Often these Advisors manage small amounts of capital, usually less than $1 billion. Their discretionary license enables them to act quickly and decisively to protect or deploy their clients’ assets.
Associate Portfolio Managers and Portfolio Managers usually have the training, experience, and regulatory ability to take advantage of high quality market timing systems. However, very few invest the time and money to develop and test trading and timing systems that they can apply confidently to client portfolios. Perhaps they have misplaced faith in the Modern Portfolio Theory they learned in school. Perhaps they haven’t heard about Behavioral Economics, or tested the assumptions of MPT with real data.
Whatever the reason, this is unfortunate, as the payoff to those who take the time to research, develop and rigorously back-test trading and timing systems can be enormous.

Consider a simple timing system for a stock market index with a single signal line based purely on historical stock market index price data. If the market index closes above the signal line, an investor would purchase stocks. If the market index closes below the signal line, an investor would sell his stocks. The following chart illustrates this approach using the Dow Jones Industrial Average from 1966 through 1983. The stock market index is the blue line, and the signal line is red. If the blue line crosses below the red line, sell stocks. If the blue line crosses back above the red line, buy stocks.

Source: Butler|Philbrick & Associates
Click for larger version.

At certain levels of granularity (for example, using monthly closing data rather than daily or weekly), such a simple system yields significant results. By broadening the system to include more asset classes (i.e. commodities, foreign stocks, etc.), and simply allocating an equal portion of portfolios to each asset class, one is able to generate impressive results indeed.
The following chart illustrates a system that discretionary managers can easily apply to client accounts. Since 1973, this system has delivered substantially better results than stocks, and at a fraction of the market risk. The system’s worst year was 2009, with a 0.01% loss on the year. Further, the system has delivered positive returns in 92% of all 12-month periods.

Source: Faber (2009), Butler|Philbrick & Associates
Click for larger version.
A corollary myth in the market timing domain relates to the assertion by many buy-and-hold advocates that an investor must be in the market at all times to enjoy long-term growth. These misinformed ‘experts’ often cite statistics that show returns to a portfolio that was out of the market for the best 10-months out of the last 10, 25, 50, or 100 years. Obviously, the returns to a portfolio that missed the best 10  months of market returns will do substantially worse than a buy-and-hold investor. What the expert fails to mention is that the best months of returns in stocks usually follow or precede the worst months of returns in stocks. Further, these best and worst months usually occur during periods where a market timing model would have parked money in cash. In fact, over the past 138 years, 7 of the worst 10 months, and 8 of the best 10 months occurred during the Great Depression!
The following chart illustrates the returns to four portfolios. The blue line shows returns to a portfolio that managed to miss the 10 worst months. The red line shows returns to a portfolio that missed the 10 best months. The green line shows returns to a portfolio that missed both the best and the worst 10 months, while the purple line shows returns to a buy-and-hold investor.

Source: Butler|Philbrick & Associates
Click for larger version.
Observe that, quite obviously, investors who avoided big losses did better than investors that missed big gains. More interestingly, investors who avoided both large monthly gains and large monthly losses experienced approximately the same return over 138 years as an investor who held stocks from start to finish.
In conclusion, individual investors have an opportunity to commit the necessary time and effort to find a qualified, licensed portfolio manager who has invested in the development and testing of trading and timing systems to best protect and grow wealth. You are likely to pay more for the services of such a team, but the value you receive in return may deliver multiples of your costs.

On Monkey Brains

It is prudent periodically to upset the apple cart in order to see what sort of rot and grime are sitting at the bottom. This series, which will include four or five posts over the next few days, will explore some common myths about investing and the investment industry.

The modern investment industry is highly motivated to conceal the realities that I intend to expose. The fat margins investment firms enjoy are predicated on the assumption that the professionals at these firms possess knowledge and information that is not available to the masses. This may be true in some cases, but large, traditional firms are handicapped in ways that more than offset this value.

The single most important take-away from this series is this: almost no one in the investment industry is motivated to take you out of the market when the risk is high. Because of this, almost no one in the investment industry is motivated to create systems and tools that signal when to get out.

Imagine for example that Fidelity, with $1.57 trillion of assets under managment, instructs their managers to pull their funds entirely out of the market. This would cause quite a dislocation. So what did they do?  As necessity is the mother of invention, large money managers invented 'buy and hold'.

In this context, it makes sense to begin with a short primer on a a relatively new investment theory called ‘Behavioral Economics’ which is rapidly gaining in credibility, even among investment traditionalists. This theory addresses experimentally the many ways that Modern Portfolio Theory, the most widely adopted model in finance, fails to usefully describe reality.

An anecdote from the book SuperFreakonomics (2009) by Steven Levitt and Stephen Dubner illustrates the power of emotional biases to short-circuit rational behavior. The book describes an experiment orchestrated by Dr. Keith Chen where monkeys are conditioned to understand the utility of money as a way to acquire treats.

Once the monkeys learned they could trade a certain number of coins for different treats, the experimenters introduced ‘price shocks’ to test the monkeys’ rational adherence to the basic rules of supply and demand. When researchers ‘charged’ substantially more for one treat over another, monkeys bought less of the more ‘expensive’ treat and more of the less expensive. The demand curve slopes downward for monkeys as it does for humans.

To test for irrational behavior, the experimenters introduced two gambling games. This is where things really get interesting.

In the first game, a monkey was shown one grape and, depending on a coin toss, either received just the one grape, or a ‘bonus’ grape as well. In the second game, the monkey was presented with two grapes to start. When the coin was flipped against him, the researcher took away one grape and the monkey received the other.

Note that in both games the monkeys got the same number of grapes on average. However, in the first game the grape is framed as a potential gain, whereas in the second game it is framed as a potential loss.

How did the monkeys react? From the book:

“Once the monkeys figured out that the two-grape researcher sometimes withheld the second grape and that the one grape researcher sometimes added a bonus grape, the monkeys strongly preferred the one-grape researcher.

A rational monkey would not have cared, but these irrational monkeys suffered from what psychologists call loss aversion. They behaved as if the pain of losing a grape was greater than the pleasure of gaining one.

Up until now, the monkeys appeared to be as rational as humans in their use of money, but surely this last experiment showed the vast gulf that lay between monkey and man.

Or did it?

The fact is that similar experiments with human beings, investors, have found that people make the same kind of irrational decisions and at a nearly identical rate. The data generated by the capuchin monkeys, Chen says, make them statistically indistinguishable from most key market investors. So the parallels between human beings and these tiny-brained food/sex monkeys remain intact.”

Loss aversion is one of the central principles of behavioral economics. The behavioral literature is consistent in observing that people are about twice as sensitive to losses as they are to gains. Investors manifest this behavior by holding on to losing positions for far too long in order to defer realizing a loss. On the flip side, investors sell their winning positions too soon in order to avoid ‘losing’ their gains. 

For evidence that you or your Advisor may be a slave to the loss aversion instinct, look no further than your portfolio. If there are many positions with large losses that have been on the books for several months or years, loss aversion is a likely culprit. Successful investors sell their losing trades quickly while letting their winning trades run.

Loss aversion is just one facet of a broader theory of investor behavior called ‘Prospect Theory’. Behavioral Economics is much broader still, and fills many of the dangerous gaps that are not adequately addressed by Modern Portfolio Theory. Some other important behavioral vulnerabilities are outlined in the diagram below (click image for larger version).

Source: Butler|Philbrick & Associates

The next post in this series will deal with timing the market. It turns out that there are tried and true rules to distinguish between markets that are likely to trend higher and markets that are in jeopardy of steep drops and volatility. It is the development of, confidence in, and above all adherence to these rules that distinguish successful investors from their poorer peers.