Occum's Razor and Stock Market Returns

In chapter 2 of John Bogle's Common Sense on Mutual Funds, he introduces Occums postulate that states: the simpler the explanation then the more likely it is to be correct.

Bogle has applied Occum's razor to all the noise that surrounds stock returns and has found that if you accept that the performance of individual securities and portfolios are unpredictable on a short term basis, one can arrive at three factors that determine long term stock performance. Those three factors are:

1. Dividend yield at time of initial investment

2. Subsequent rate of growth in earnings

3. The change in the price-earnings ratio during the period of investment.

Bogle then states that since 1926 that less than 20% of the markets return has been due to speculation. The majority of return is due to the two other factors: dividends and earnings growth.

He states that speculation is almost a neutral factor in the nature of long run returns.

This is important. It means that even if you had a speculative edge, over the long run, your advantage is not that great. Not to mention that the transaction costs involved may eliminate any edge you may have.

Occum's razor applied to the stock market: returns over the long run will equal dividend yields + long term economic growth. everything else is noise.

2 Reports from WSJ - How would Dilbert Invest & Chance

In todays WSJ there are two good articles on investing. Both emphasize the use of index funds:

http://online.wsj.com/article/SB10001424052748703724104575379281901045278.html?mod=ITP_thejournalreport_0

http://online.wsj.com/article/SB10001424052748704913304575370913870866820.html?mod=ITP_thejournalreport_0

Long Term Investor: No Excuse not to Index - a table, a chart, a graph

The following table and chart are re-creations of a table and chart published in John Bogle's Common Sense On Mutual Funds. I believe that a short analysis will explain the argument for long term investors to simply hold the total market versus paying active managers to pick stocks or sectors.

A review of the chart shows that the average 1 year US stock market return since 1802 has been 6.5% (adjusted for inflation) with a one year high of 61.4 and a 1 year low of -48.4.

It also shows that as time passes the average return on the US stock market goes up and its highs and lows go down. For example the average of all 25 year holding periods is 6.9% with a high of 11.1% and a low of 2.7%. That means that any investor that held the US market for any 25 year period never had a 25 year return higher than 11.1% or lower than 2.7%. The numbers for a 50 year holding period are even more dramatic.

Now I need to bring in the definition of standard deviation to fully make the argument for holding (or indexing) the total US market.

Standard deviation measures the spread of the data that makes up the average. So a larger standard deviation means that the data that make up the average are spread farther apart than lower standard deviation averages. The chart and table above demonstrate this: in any 1 year the US market had returns that could have been anywhere between 61.4 and -48.4. But if one held the US market 50 years the spread of returns ranged between 3.9 and 9.9 (the 50 year holding period has a lower standard deviation).

Stay with me.

Statisticians have found that most averages have data that falls within 3 standard deviations (SD) of the average and that the data points make up a "bell shaped curve"

The graph below shows this idea. Generally, 68.2% of the data points that make up the average fall within 1 SD, 95.4% fall within 2 SD and 99.6% fall within 3 SD. Standard deviation is represented below by the Greek symbol sigma ( σ ).

3.9%... 4.9% ...5.9%.. 6.9%.. 7.9% ..8.9%...9.9%

Average return for the corresponding standard deviation for 50 yr holding period

So what does all this mean for long term investors? It means this: If you had simply held an index fund of the total US market over the last 50 years you would have earned 6.9%. You would have had a fee of .20% (index funds are very cheap - there is no work to do) and your net after inflation return would have been 6.7%.

If you paid an advisor to actively manage your investments, or used an actively managed mutual fund, you had a 50% chance of being above average. Now factor in fees of 1.5% (average of mutual fund or personal advisor fees) and you would have had to had a return of greater than 8.2% (8.2% - 1.5% fees = 6.7%) to equal the return of holding the index and just being average.

Note: that actively managing means that someone is picking stocks and buying and selling based on what they feel is the best time to move in and out of certain stock positions.

If you earned an 8.2% return you would have been in the greater than 1 standard deviation range. Remember for the 50 year time period the standard deviation was 1%. A look at the graph above will show that your return would have been in the top 10 to 16% of returns.

Anything less than an 8.2% return and your performance is less than average after fees.

As an investor you need to ask: what are my odds of achieving higher than average net returns?

Finally, I want to emphasize that studies also show that the stock picker or mutual fund that does great one year or for several years does not maintain that position. So, to add to the above question, one needs to ask: can I consistently pick the advisor, mutual fund or stocks that will, net of fees, outperform the average of the US stock market.

My advise: ACCEPT AVERAGE and by doing that you are FAR ABOVE AVERAGE, NET OF FEES.

In further blogs we will explore what stocks tend to fall in the above average part of the bell shaped curve and why. Preview: they do not get there without a cost, and that cost is volatility - risk.

Yale Endowment: Superior Intelligence or Higher Risk

Are superior returns due to superior intelligence or adopting a riskier investment portfolio? This is a topic which I will explore continually. Larry Swedroe discusses David Swensen's performance at Yale.

http://moneywatch.bnet.com/investing/blog/wise-investing/is-david-swensen-lucky-or-good/1507/

Blog post on Indexing by Larry Swedroe

Short blog post by one of my favorite investing writers: Larry Swedroe.

In this post Larry gives an explanation of why investing with index funds results in superior returns.

http://moneywatch.bnet.com/investing/blog/wise-investing/do-you-want-to-be-just-average/1468/?tag=col1;blog-river

The Father of Modern Portfolio Theory Speaks

There is a collection of accepted learning in the field of financial economics known as Modern Portfolio Theory (MPT). MPT is so commonplace now that it is hard to believe that it was revolutionary 50 years ago. That was when a Phd student at the University of Chicago, Harry Markowitz, argued that there was a trade off between risk and return. He demonstrated, mathematically, that investors are rewarded for the level of risk they take He also showed, that for every level of risk taken, there is a combination of investments that is the best combination available for that level of risk. Most of us who have investment portfolios have a portfolio that combines different asset classes (US Stocks, international stocks, bonds). This type of diversification was all started by Harry Markowitz.

The portfolio model Markowitz invented was based on the statistics of mean (average) return and the variance of the data points around the mean. These models would say something like - if you invest in a 100% stock portfolio you could have a one year return of negative 50% a couple times a century. A good financial advisor should explain that to an investor.

In 2008 the market experienced one of those couple times a century years. Some in the financial press shouted that MPT failed. I have to say, that when I would read or hear this I struggled, because 2008 was not outside what the models FOR PROPERLY DIVERSIFIED PORTFOLIOS predicted. This is not to say that other models that the banks and others were using to make bets on the housing market did not fail, they did. But if you were an average investor who had a portfolio built on an MPT foundation, your return was within the prediction of the model.

Attached is a great interview with Markowitz in last months Journal of Financial Planning:

http://www.fpajournal.org/CurrentIssue/TableofContents/May201010Questions/

Here he explains and defends MPT. He is a modest genius who should be read and listened too.

Bogle on long term investing

In chapter one of Common Sense on Mutual Funds, John Bogle makes the following recommendation on stocks: He states that based on the historical evidence, if your definition of risk is the failure to earn a positive real return (your investments outperform the rate of inflation) over the long term, then stocks are actually less risky than bonds. He says that if you believe that the economy will be healthy over the long term, then the best way to outperform inflation is the stock market.

But, you must be prepared for periods of negative returns. Sometimes over several years.

It is important to note that Bogle defines risk as an investment that does not outperform inflation. Some investors cannot stomach the ups and downs of the stock market and for them, risk is having their investment earning negative returns. Outperforming inflation does not matter to them.

Also note that he is stressing this for the "long term investor." My advise on the definition of long term is 10 years or more. Therefore if you have need for your money in a period of less than 10 years the stock market may not be appropriate.

Finally, Bogle stresses the need to include Bonds in your investment portfolio. Bonds will generally act as insurance to your portfolio during poor stock market periods.

I will discuss portfolio allocations and risk issues in future blogs.