Swedroe comments on buying individual stocks.

[Nords]

One of the reasons I enjoy a good discussion board is reading things that could change my thinking. Hey, it could happen, because objective criticism helps me refine my bright ideas. If my carefully-reasoned logic can't survive a query by the Internet's dogs (or 14-year-olds from Missoula), then I probably need to do more careful reasoning. And if I can't explain an investment idea to you guys then I'm certainly not ready to explain it to my spouse.

Criticism is even more compelling if it comes with credibility. After a lawyer-inspired hiatus, Larry Swedroe has resumed posting to the Vanguard Diehards board. Larry's latest thread raised an old issue in a new way:
"One should be expected to be rewarded for investing in the market because stocks are riskier than Tbills. That is called the risk premium. No rational person would invest in the market if they did not expect to be rewarded for taking incremental risk.
"The risk of the market cannot be diversified away--no matter how many stocks you own. Thus it is called systematic risk, for which you are compensated with an EXPECTED risk premium.
"Now individual stocks have risks unique to them (see Merck and Enron for two examples) and thus they have unsystematic risk which can be diversified away. The markets don't reward you for taking risk that can be diversified away. Thus you [in individual stocks] take far more risk with no risk premium. You certainly increase the potential dispersion of returns. No one ever lost 100% of their money invested in the US market. Many people have lost 100% of their money, including large fortunes, investing in one or a small group of stocks. Dispersion matters.
"And note something most people don't understand. They think that stock selection is a 50-50 game. Half the stocks will outperform and half underperform. But this is NOT true. You can only lose 100% but you can make 10,000% or more. So one great winner can more than offset many losers. Thus there are more stocks that underperform than outperform. Thus the odds are actually against you, and you are taking more risk.
"Here is a great example, a study on small stocks found that less than 1% of all small stocks provided ALL of the small cap premium. Now with thousands of small stocks what are odds that an investor has even heard about the few that turn out to produce the outperformance, let alone research them and end up owning them?
"Being involved certainly involves time and effort. And the evidence from studies is that individuals buy stocks that subsequently underperform and sell stocks that subsequently outperform. But IMO what is the real "crime" is that the time you have to spend being involved could be spent on what IMO are much more important things-things that with 100% certainty add to the quality of your life. Things like doing homework or playing with your kids, having a glass of wine with your spouse and talking about their day, doing community service, reading a good book, playing tennis or golf, or whatever are the "big rocks" in your life.
"Even if you are among the very few that win the game of investing the price might have been that you lost the far more important game---the game of life. It is my own experience that one of the greatest benefits investors that adopt passive investing receive is that they no longer have to spend (or waste) time paying attention to the market. Instead they get to enjoy their life far more.
"As you may know I went to school to be a security analyst and eventually hoped to be a portfolio manager. Luckily life took me on a different path. But I spent many years buying individual stocks and lots of time researching them, etc. I no longer waste any time on such minor things, things likely to prove counter productive anyway. Yes trying to beat the market can be exciting. But spending more time with my family, or reading a good book, is a lot more important. And a lot more beneficial."

I'm surprised to find myself agreeing with Larry. He makes a very good point about maximizing the odds and not letting research interfere with more productive activities. I've read Gilovich & Ellis about investing psychology and minimizing losing. I've always felt that if I had the time and learned what I was doing then I'd be able to beat an index and realize 15%-20% APY. However it's taken a lot longer than I expected to achieve any of that, let alone all of it, and I'm not sure that it will continue to be worth the effort. I would've made far more profit putting my "brilliant investor" money into our retirement portfolio instead of stumbling around looking for new clues stocks. However this tuition has paid off in an even bigger way by sucking all the romance & mystery out of getting rich quick. A small pot of money has satisfied my curiosity while keeping me from being tempted to mess around with the retirement portfolio. Ironically as I'm beginning to consider shutting down the project, its returns are starting to take off.

I'm far more experienced at cutting losses than I am at taking big gains. IOW it takes a lot of disciplined losing to find a big winning stock to tip the scales. Even finding the winners, let alone buying them, requires patience measured in months rather than weeks. I've probably run the gamut of investing styles (excluding options) and I have to admit that I've only really had my interest tweaked by shorting stocks. In a sideways market that's been a very reliable way to make money, and it's a lot easier to predict what's going down than it is to see what's going up. I can learn to do every other type of investing, but I'm not that motivated and it's cutting too much into surfing family time.

Another indicator that my stock ardor is cooling is my screening tools. I've learned a lot about the theory and I can work my way through SEC filings & financial footnotes, but somehow I just haven't gotten around to developing & using a tool that will pop up a good idea among 20 candidates. That's probably my most important focus next year-- developing a screening tool that I'll actually use.

Otherwise I'm with Bernstein & Swedroe: small-cap value offers the highest risk premium. Anything beyond that is additional risk (volatility) without probability of additional profit.

So I'll probably stop buying individual stocks in favor of undervalued indexes. I don't think I'm through shorting stocks yet-- I still can't resist watching Martha Stewart take her company back down into the toilet... again.

Your objective criticism thoughts?

 

[brewer12345]

My experience has been different, so naturally I have a different view. I have had a few epic losers in my portfolio, but the winners have far and away outweighed the losers. In part, I started picking individual stocks because I started investing in 1999, when it was very clear (even to a neophyte like me) that the equity market was very, very irrational. The money had to go somewhere for a return better than a savings account, and the only thing I knew about was equities. So I started picking individual businesses to invest in. Since I knew the indexes were ridiculously overvalued, I started out (and continue to) looking for attractive stuff that was available for cheap. I found it mostly in the stocks of small companies that the market was ignoring or misunderstanding, and that is still where I find the best stuff.

I have no intention of blindly investing in the indexes in asset classes that I can understand and exploit. I am now starting to short a lot of stuff, either openly or via puts. I think that holds the potential for even better returns than going long SCV. Why? Because so many investors either won't or are not allowed to go short. Any time there are restrictions, there is money to be made for nimble players.

Naturally, if you don't have the time, inclination, or aptitude, indexes may be a very good idea.

 

[Eagle43]

I thought Larry Swedroe's insight is brilliant.  Buying the indexes is the only risk I wish to take, especially at my age.  And I certainly don't have the smarts, the desire or the insider wherewithal to pick individual stock winners.  So, what's left?  A tip, a hunch?  You call me and tell me you know that XYZ is going up or down and to invest accordingly? A good way to "go down with the ship." Here's a question for all.  Who on this forum actually pegged Microsoft when it was nothing? Just asking?

BTW:  If you come up with a great (perfect) screening tool, will you share??

 

[saluki9]

When I first took an interest in investments, I was a freshman in high school. I was convinced that I needed to become an equity analyst. I spent 5 years in college and now 6 years on the job studying and working with stocks day and night. I also spent three years of my working life studying for the CFA exam. I can honestly say now that my experience in this business has shown me that security selection is a total waste of time (IMHO) and I no longer own any individual stocks.

I'm very thankful that I found a job working for a firm that believes in (and practices) passive management, although that is not the reason for my conversion. My own research, and that of many people smarter than I has shown me that diversification and asset allocation are where my efforts are best spent.

I don't want to criticize people who choose to buy individual stocks, to each his own.

 

[wabmester]

Who on this forum actually pegged Microsoft when it was nothing? Just asking?

I owned MSFT, INTC, and DELL in the 80's when they were relatively nothing.   At the time, it was obvious to any software geek that Microsoft and Intel had a monopoly that would allow them to ride the PC growth coat-tails.   And DELL was just another proxy for the PC market.

In any case, Swedroe is just giving the standard Fama/French spiel.   My questions about that spiel are

1) Can the ScV risk premium persist?   In general, such premia get "rationalized" away.   If everybody "knows" it exists, it stops existing.

2) Is the overall stock market risk premium too low?   A lot of things suggest that people are underestimating the long-term risk and overestimating the long-term returns.

3) Is it really that hard to catch the 1% of the stocks that carry most of the return?   I like Buffett's advice: buy stocks like you only get to buy, say, 20 in your lifetime.    Ignore the noise and concentrate on "blatantly obvious" trends and values.

 

[brewer12345]

2) Is the overall stock market risk premium too low?   A lot of things suggest that people are underestimating the long-term risk and overestimating the long-term returns.

I would argue that the answer for the equity market is "yes". Plus, spreads in the junk market are absurdly low, and I cannot rationalize 10 year treasury yields under 5 or 6% when inflation is 3+% and on a clear upward trend.

 

[yakers]

Its interesting that there really are different ways to succeed financially. Some people do real estate, some open their own business some live cheaply and save mightily. I had a Quick & Reily trading account which I closed because it was taking too much time and the trading costs were too much even though I really minimized them. My overall financial plan is based on owning my home, a govt pension, TSP(401k type) account, an old IRA, a Roth IRA, a very few $ in ibonds and several DRIP stocks. These are low or no fee DRIPs. The nice thing about the DRIP approach is that you cannot market time. For me it is a monthly DCA into 6 stocks, $50 or $100 a month. One (BWA) I owned for 5 years and the others 3 years or so. A simple chart of these stocks (BWA, WEC, UST, MOD, HNZ, KEY) show a pretty good record over that time VS the S&P. But the basis of selecting a company is not just a recent quarterly report. Dollar cost averaging takes a lot of excitement out of the process and these are pretty boring stocks.
But rather than looking for the 10 bagger why not just get boring old stocks that only slightly outperform the S&P500? And holding individual stocks lets me have different tax strategies, I could tax harvest if I had losses and there is a good tax rate on dividends. I expect to retire in the next year or two and I expect to then stop reinvesting dividends and just use them as part of my cash flow. If I never sell the stocks will pass on to heirs on a current market value basis.
But I don't see the big boys (Bernstien, Swedroe, Bogle) address this approach. Its not really trading but it is investing. Anyway, in my plan there is a place for individual stocks even if I agree that trading stocks is a fools game.

 

[Cut-Throat]

2) Is the overall stock market risk premium too low?   A lot of things suggest that people are underestimating the long-term risk and overestimating the long-term returns.

When you say people, do you mean people on this forum or people in the World? Please elaborate for us.

I don't see any folks on this forum thinking they'll put money in the S&P500 index fund and rack up 12% a year with 3% inflation. Most of us here are pretty conservative.

In fact, personally I would have no trouble if my portfolio just kept up with inflation with 0% growth. 1% real would put me on easy street. Is this overestimating the long-term return? Please give me your definition of a reasonable estimation. I do understand volatility and RTM, so no need to cloud the discussion.

 

[wabmester]

When you say people, do you mean people on this forum or people in the World? Please elaborate for us.

People who invest in the stock market.   Most of the people in this virtual room included.   Your expectations are probably lower than average, but you apparently believe that you are guaranteed positive returns if you stay in the market long enough.

I thought I made my views of the stock market pretty clear after 1000+ posts, but here it is again in a nutshell:

1) The market is basically a proxy for the economy, so one risk that just about everybody seems to dismiss is that the US economy will grow significantly slower than the historical rate.   I think this is a very real possibility for a bunch of reasons.

2) We all know the dog walking on the leash story, but nobody seems to realize how long that leash is and how far the dog can wander.   Even if our economy does well, there's a significant probability that the stock market can be beaten down for longer than you can afford to wait for the dog to follow Mr Economy again.

3) Even Bernstein/Swedroe/Bogle expect that if the dog doesn't stray too far, we're still looking at 6% nominal long-term growth due to inflated P/E's, reduced risk premium, recent bubbles, etc.

4) As early retirees, I think many on this board underestimate their ability to stomach volatility.    All of us here have pretty good-sized nest eggs, so for us, keeping volatility and inflation at bay should be primary considerations (vs growth).    The stock market isn't necessarily the best place to avoid volatility or inflation effects, and it's likely that few of us have really been tested in this regard.

 

[Cut-Throat]

People who invest in the stock market. Most of the people in this virtual room included. Your expectations are probably lower than average, but you apparently believe that you are guaranteed positive returns if you stay in the market long enough.

I thought I made my views of the stock market pretty clear after 1000+ posts, but here it is again in a nutshell:

1) The market is basically a proxy for the economy, so one risk that just about everybody seems to dismiss is that the US economy will grow significantly slower than the historical rate. I think this is a very real possibility for a bunch of reasons.

Well, if I understand what you are saying is that since I believe that if you stay in the market long enough (30-40 years) my returns will be positive. And that if the market is a proxy for the economy, you believe that the U.S. economy could be in a recession for 30-40 years!

What I was hoping you would give me is your prediction of a conservative number for estimating say a 50/50 portfoilo?

 

[wabmester]

Well, if I understand what you are saying is that since I believe that if you stay in the market long enough (30-40 years) my returns will be positive. And that if the market is a proxy for the economy, you believe that the U.S. economy could be in a recession for 30-40 years!

The rule of thumb is that the market returns GDP growth - 2% over the long term. If we simply extrapolate our past growth to the future, the gurus I mentioned believe that we're looking at maybe 6% nominal, right? That doesn't factor in any long-term economic slowdown. The CBO estimates that the retirement of the baby boomers *alone* will knock 2% off of our forward GDP growth. So, that 6% becomes 4%. And that doesn't factor in anything else, such as the changing character of our economy from manufacturing to services, the enormous debt burden, etc. You only need to look to Japan and Germany to see how demographics affects market returns, but they don't have our debt burden and other factors.

What I was hoping you would give me is your prediction of a conservative number for estimating say a 50/50 portfoilo?

The problem I have with that is that the bond component is predictable. It's whatever your bonds yield is. The stock market portion of that has a wide range of outcomes. As an investor, you should characterize risk as something like:

1) What are the possible outcomes

2) What is the probability of each outcome

3) What is the seriousness of each outcome

4) What can I do to mitigate the risk, and what is the potential cost of that mitigation

It's not as simple as saying that the most likely outcome is X% over Y years. What I think people universally tend to underweigh is the seriousness of the low-probability outcomes. And that's the sort of thing that would keep me up at night. As a retireee, I strive to be worry free.

 

[Cut-Throat]

What I think people universally tend to underweigh is the seriousness of the low-probability outcomes. And that's the sort of thing that would keep me up at night. As a retireee, I strive to be worry free.

Well (sigh!)

I never got an answer to my question. And yes, you seem to worry more than anyone I've ever seen.

 

[wabmester]

CT, you're right.   You deserve a simple answer to a complicated question.

The answer is 42.

Edit: Look, the odds are on the market doing pretty well over the long term. There's always the chance, however slim, that long-term returns will be negative. There's also a slim chance that long-term returns will be through the roof. So, the way I approach this is:

1) Start with more money than you need
2) Protect a core nest egg with very conservative investments (like TIPS) that will cover your basic needs
3) Keep some real assets for an unmitigated disaster in case you need to trade something with the invading forces, for example
4) Take the rest, and put it in more risky investments, like the stock market

I might have 50 years ahead of me. That's a frickin' long time. A *lot* could happen.

In my absolute worst-case scenario, my assets survive long enough for me to try to get back on my feet.

In my pretty-bad scenario, I have to tighten my belt.

In my best-case scenario, I become filthy rich.

I honestly don't spend time worrying about bad things happening, but I am interested in finding holes in my mitigation strategies and adjusting to new information.

 

[Cut-Throat]

CT, you're right.   You deserve a simple answer to a complicated question.

The answer is 42.

Then why bother speculating! - Why take 10,000 words to say that you don't have a fricken clue?

 

[wabmester]

Then why bother speculating!  - Why take 10,000 words to say that you don't have a fricken clue?

I'm retired. Why do you think?

Entertainment.

 

[cute fuzzy bunny]

Lots of strong opinions considering not one of us really knows whats going to happen.

The good news is we're real nice to each other about our complete lack of knowledge

The thing is, its a nice idea to find those 20 "great" companies. Perhaps it was "obvious" to some in the 80's that microsoft was going to be what its become. It looked like a 5th wheel to IBM to me, and I thought for sure that Billy's gamble to drop OS/2 in favor of windows was going to be the punchline to some harvard business school paper about how microsoft blew it.

I also enjoyed the late 99 issue of some well regarded financial rag that I read in my doctors office in 2002, crowing about how no matter how expensive they were, you just had to own worldcom and enron, as they were the bluest of blue chips and would highlight the next 20 years of "must own" stocks. I couldnt find fault with their logic, even though I had a few extra years of knowledge they didnt have at the time. I just never bought them because buying phone and power companies at P/E's in the 70's never appealed to me.

I do believe that buying the right companies makes you rich faster than any other way. I also believe that people who "found" those companies did so through dumb luck or coincidence rather than smarts or tools. But to be fair, you can screen out some down on their luck companies that have good prospects and maybe luck out on some.

I'd rather get rich slow. Err...stay rich slow.

 

[wabmester]

Well, I did pick MSFT, INTC, etc in the 80's. But I also bet big on Japan, Inc. That was a brilliant move till about 1990....

Japan represents one of those low-probability bad outcomes I keep yammering about. Perhaps the fastest growing economy in the world. It became the second biggest economy in the world. Lots of smart, hard working people that were kicking our butt in consumer electronics and automobiles.

So, what happens to CT-San in a hypothetical alternate universe?

The year is 1990. CT-San is 55 years old and made a killing in the stock market, so he decides to retire early. He asks his guru Sensei Swedroe for investment advice. Swedroe says to be conservative: 50% in total market index, 50% in short-term bonds.

Cut to the present. CT-San is now 70 years old. His stock investments are worth 25% of their initial retirement value, and that doesn't account for withdrawls. His bonds yield around 1%. CT-San is hosed.

Low probability. Serious consequences. Avoid that combination, even if it means giving up some upside.

 

[cute fuzzy bunny]

Wow Wab...thats amazing! How did you find out whats going to happen over the next 15 years?

What are you, Hosuc now? Do you do this with a magic tool or without?

 

[wabmester]

Oy vey. Empty set, did you notice the "low probability" part? It wasn't a prediction of our imminent future. It was a *risk* that you (and ONLY you) should completely ignore. OK?

 

[unclemick]

Hmmm - the game is afoot - one more time.

To repeat:

Postscript, 4th ed, Ben Graham's The Intelligent Investor - the gust of which - it only takes one stock whether you picked it by luck or skill is a matter of belief.

Or you goggle up Bernstein's - The 15 Stock Diversification Myth - which if you read 'lefthandedly' - heh, heh,heh - your odds are one in six - better than lotto - AND they have winter snow in Missouri.

75% balanced index, 10% REIT index - and, and 15% individual stocks.

Hope springs eternal.

P.S. - the 10% REITS are to help the wider woman (Norwegian) - to bump up the the overall portfolio dividends.

 

[JPatrick]

Well, I did pick MSFT, INTC, etc in the 80's.   But I also bet big on Japan, Inc.    That was a brilliant move till about 1990....

Fast forward to 2005 and lo and behold Japan is rising again.
Another big bet might be good again.  I tossed my chips down a few weeks ago 8)

 

[wabmester]

Fast forward to 2005 and lo and behold Japan is rising again.
Another big bet might be good again.  I tossed my chips down a few weeks ago 8)

I'm still holding my original position from around 1985. I'm sure I haven't hit break-even yet. But, I have continued to stupidly double-down along the road to ruin. I'll probably never give up on Japan, but I really don't expect them to grow very fast. I would *love* to get a piece of a J-REIT, though.

 

[lazyday]

Look, the odds are on the market doing pretty well over the long term. There's always the chance, however slim, that long-term returns will be negative. There's also a slim chance that long-term returns will be through the roof. So, the way I approach this is:

1) Start with more money than you need
2) Protect a core nest egg with very conservative investments (like TIPS) that will cover your basic needs
3) Keep some real assets for an unmitigated disaster in case you need to trade something with the invading forces, for example
4) Take the rest, and put it in more risky investments, like the stock market

Something along those lines would be nice, but I don't have enough $.
Instead of holding lots of riskless assets, my fallback plan is to work if markets do poorly enough.
Otherwise, if I wanted to be prepared for truly horrid future returns, I'd have to work... now.

 

[justin]

Fast forward to 2005 and lo and behold Japan is rising again.
Another big bet might be good again. I tossed my chips down a few weeks ago 8)

I'd have to say my current investment in the Vanguard Pacific stock index fund (primarily a Japan Stock index fund) has been my best investment ever. I was lucky when I started buying three months ago and already have double digit gains. It was my first Vanguard fund and I decided to start a passive diversified index based approach to investing. I looked at all the indexes out there, and decided Japan was the most beat up, the least talked about, and had an amazing price to book ratio. I thought I was using skill, but in hindsight, it was probably luck. Unfortunately for me, it took off too quick for me, since I'm still DCA'ing into it!

 

[wabmester]

Since we're talking about individual stocks and Japan, here's my pick. As I mentioned, I only pick individual stocks once in a blue moon, so I like to focus on a combination of value and long-term growth prospects. The last big position I took was in Toyota (TM) in 2003. It basically is the Japanese market (largest cap on the NIKKEI), it had been beat up for no reason, and it was clear that they were taking market share away from US makers, maintaining high margins in the face of US price cutting, and had come out with the best hybrid solution. So far, it's gone from 40-something to 90 in that timeframe. I don't expect it to continue to grow at that rate, but I do expect it to remain one of my long-term holdings.