Discipline is Difficult

Thursday, August 15, 2013 15,812 views

Mark Hebner: Welcome to IFA.tv, I am Mark Hebner, President of Index Fund Advisors and today we're here to continue our education and help you get away from your speculation. Today we've got another special guest, Weston Wellington, from Dimensional Fund Advisors.

Weston's a Vice President over at Dimensional and a member of their all important research team there. He's also known on a global scale as being one of the foremost educators on how capital markets work. We're so proud to have him here doing a three- part series, and you're going to love his radio voice as he confidently explains to you an all important topic about why discipline in investing is so difficult. Weston, welcome back to IFA.tv.

Weston Wellngton:  In this session we're going to talk about discipline, more specifically, "discipline in the investment arena." And I want to make the case that discipline is a challenge for almost all of us as investors.

I'm going to throw up a home-made formula here...

Investor Return = (m-c) x b

m = Capital Market Return

c = Costs

b = Investor Behavior

Every investor's return is a function of these three factors. There's a return on the securities markets, stock markets, bond markets — and we can easily capture that return by simply buying and holding a large basket of securities.

We're going to take a small haircut – or in some cases a not so small haircut if we're not careful. With investment costs, there may be fees, commissions or various charges.

So our return is a function of gross return of all the securities minus the costs whatever they are that we might bear times the ‘b' factor  – that I'll call the behavior factor.

...and I say times because the behavior factor could be a positive or a negative. These two factors – the large factors, the capital market return and the investor behavior are the key drivers of every investor's results.

Based on my experience over the last 35 years in the investment business, I believe that investor behavior is just as important, perhaps even more important, than the return available in the capital markets.

And I started in the investment business back in the mid-1970s, and the 1970s were not a particularly rewarding period for stock market investors — and for many of us, it was a very stressful time. It seemed like interest rates and inflation kept going higher and higher and higher. Stock markets went up and went down but didn't seem to make much of the way in real progress, and the general level of investor anxiety was captured very well by a cover story that appeared in Business Week in August 1979...August 13th to be precise...and the cover story proclaimed, "The Death of Equities."

"The death of equities is...a near permanent condition..." Business Week

This is back when most business magazines tended to write much longer and more in-depth articles — and let me assure you, it was a very discouraging article for any young person in the financial services industry. The article quoted expert after expert painting a gloomy picture that inflation, high interest rates — they were apparently baked into the cake all around the world ‑ there was no way out.

And that stocks could no longer compete for investor attention in this new environment, this new world order of high inflation and high interest rates. Stocks, the article suggested, might be appealing if you were very nimble and you wanted to trade in and out of them — kind of like commodity futures contracts...but for a long-term buy and hold investor, the message was, "equities are dead and they're not coming back."

On that day, August 13th, 1979, the Dow Jones Industrial Average closed at a shade over 875. (875.26)

And as it turned out, three years went by and on August 12th, 1982, prices were essentially where they were in August of ‘79. They had made essentially no progress; they were slightly lower actually. And so at least initially, the prediction of this particular article seemed to be very accurate.

But as it turned out, that was the last day of the so-called bear market of that particular cycle, and the first day [after] became [started] one of the longest and strongest and most explosive bull markets in American history.

Ten years later (August 13th, 1989), the Dow Jones Industrial Average) tripled (2683.99); twenty years later it was up 12 times in value (10,973.65 on August 13th, 1999); 30 years later up 15 times in value (13,169.43 on August 13th, 2012) — and that's just assuming a price only calculation that ignores the impact of dividends. Well, if we include reinvested dividends and using monthly data now from 1979 through the present as of May of this year*, a $10,000 investment grew to over $534,000.

*August 1,1979 to May 31, 2013

So apparently equities made a rather dramatic and unexpected recovery from the graveyard after all.

The point of this exercise is to stress that it's extraordinarily difficult to predict what the financial future may hold for us, and we should be very skeptical of our ability or anyone's ability to tell us what the long run behavior of the equity markets is likely to be.

Do news events predict stock prices?

Just to focus on one sub-set of financial news* in recent years. As most of us are aware, it's been a painfully slow recovery... using broad economic indicators ‑ unemployment being a good example.

*some media headlines: The Bubble Has Burst, Wall Street Crashes, Financial Disaster, Scandal, Crisis Ahead, Investment Decreasing, Inflation, Investments in Jeopardy

After the dramatic downturn in the financial markets in 2008 and the onset of a recession, unemployment surged in 2009 to the highest level in 26 years (Alan Rappaport and Anna Fifield, "Jobless Figures Surge to 26-year High," Financial Times, September 5, 2009).

The following year unemployment in one of the largest states in the country hit a new record high of 12.60% (Alana Semuels, "California Jobless rate hits 12.6%, LA Times, April 172010)...

...and the following year the news was slightly better but hardly encouraging (Sara Murray, "Weak Hiring Casts a Cloud," Wall Street Journal, January 8, 2011)...

— And it wasn't just in the U.S. but in countries around the world. Particularly Europe struggled with high unemployment (Brian Blackstone, "Poor Economic Data Slam Europe," Wall Street Journal, March 2, 2012)

— And in the European area in particular earlier this year, unemployment hit a new record high (Paul Hannon and Alex Brittain, "Euro-Zone Unemployment Hits New High," Wall Street Journal, January 9, 2013).

Meanwhile, job growth in the U.S. was slowing to a trickle (Brenda Cronin, "Job Growth Slows to a Trickle," Wall Street Journal, April 6, 2013)...

— And various measures of unemployment performance were so called ringing alarm bells (James Politi, "U.S. job figures set alarm bells ringing," Financial Times, April 6, 2013).

What was the behavior of the equity markets as measured by the S&P 500* over the same time period? Well, we saw variation in returns, no question about that…but did we see a consistent pattern of negative results that might have been explained by this uncomfortably high level of unemployment? Actually, the rate of return on stocks over this particular 4 plus-year period was well above average.

behavior of the equity markets as measured by the S&P 500


Now the message here is not a suggestion that we can simply ignore all economic data and assume that stock prices will have a repeat of this kind of performance over any future four and a half year period — but the message once again is to be very skeptical of our ability to read a listing of today's economic events or tomorrow's expected future economic events and attempt to outwit other investors in assessing what should our portfolio strategy look like.

Far too many investors fail to achieve the simple capital market rates of return that were there for the taking by failing to have a broadly diversified, consistent investment strategy that was designed to be an appealing solution in any kind of economic environment — expansion, recession, or we're uncertain which...

One might even describe this approach as some sort of a ‘Tradeless Nirvana' where we abandon the effort and the stress of constantly trying to predict the future and constantly fiddling with our portfolio in an effort to profit from these predictions and instead identify what long run risk exposure makes sense for an individual in our position given our age, our income, our human capital projections etc. —  and then just let the power of the capital markets work on our behalf. 

We are harnessing the forces of free enterprise all over the world.  Although we have no guarantees, we expect a positive return on our capital because we are providing a key ingredient for the functioning of any economy ‑ the capital we supply, which business owners and entrepreneurs use to finance their business operations, and that cost of capital for that business of our investor return.

But the way to assure ourselves – the most likely way to assure ourselves of achieving that market rate of return – is to adopt that‘Tradeless Nirvana' approach…and rather than try to outwit the markets and see them as our adversary, [we should] harness their full power and let them work for us on our behalf.

"Don't just do something, sit there!"






dimensional fund advisorsdfaweston wellingtonbehaviors p 500