Download - Stock Market Investing for the 21st Century
Stock Market Investing for the 21st CenturySteven Thorley and Grant McQueen
• Lesson 1: Invest in stocks for the long-run
• Lesson 2: Free-ride on the market competition
• Lesson 3: Avoid the hidden price-tags of trading
• Lesson 4: Don’t fall into the data-mine
Stock Strategies: Four Important Lessons
• Topics not in this presentation
– Personal finance– Get-rich-quick schemes– Beating the market
• picking stocks
• market timing
– Hot tips– The things that matter most
• family
• health
• gospel
Stock Strategies: Four Important Lessons
• Lesson 1: Invest in stocks for the long-run
– Stocks will have higher returns, on average
S&P 500 Small Cap T-bond T-bill CPI
11.88% 14.16% 5.95% 4.75% 3.74%
Wealth Index for U.S. Capital Markets 1947:12 to 2007:12
$0
$1
$10
$100
$1,000
$10,000
Dol
lar
Val
ue (L
og S
cale
)
S&P500 SmallCap T-bond T-bill CPI
$844
$2827
$32
$16
$9
The Long-term Return on the Stock Market
Stock market risk-premium = market return - risk free return 7.13% = 11.88% - 4.75%
… but the U.S. in the last half-century has been “lucky” compared to other developed markets and time periods.
Going forward, the expected stock market risk-premium is about 5 percent. With the risk-free rate at about 3 percent, the long-term expected return on stocks is about
8 percent per year
(standard deviation of 20 percent per year)
Stock Strategies: Four Important Lessons
• Lesson 1: Invest in stocks for the long-run
– Stocks will have higher returns, on average
– Stock market risks are acceptable, if you:• Diversify
• Invest for the long-run
Diversify Across StocksDiversify Across StocksA
vera
ge a
nnua
l sta
ndar
d de
viat
ion
(%)
49% -
24% -
19% -Total Risk
Diversifiable Risk
Nondiversifiable Risk
Number of stocks in portfolio
1 10 20 25
-30%
-15%
0%
15%
30%
45%
60%
1 5 10 20
Holding Period (years)
Best and Worst Annualized Returns(1948-2007)
S&P 500
T-Bonds
T-Bills
Based on compounding annual returns from Stocks, Bonds, Bills, and Inflation., 2007 Yearbook, Ibbotson Associates
0%5%
10%15%20%25%30%
1 5 10 20
Holding Period (years)
Chances of Loss(1948-2007)
S&P 500
T-Bonds
T-Bills
Based on annual returns from Stocks, Bonds, Bills, and Inflation, 2007 Yearbook, Ibbotson Associates
From: “The Time Diversification Controversy” by Steven Thorley, Financial Analysts Journal,Vol. 51, No. 3, pp 68-76 (May/June 1995).
Table 1. Risk-Free versus Risky Investment Optionsunder Different Investment Horizons given $1,000
Horizon Risk-Free ------------ Risky Value ($) ------------ Under-Performance(years) Value ($) Mean 10 percentile 90 percentile Probability (%)
1 1,041 1,142 918 1,384 30.95 1,221 1,943 1,152 2,882 13.2
10 1,492 3,773 1,736 6,350 5.720 2,226 14,239 4,406 27,578 1.340 4,953 202,755 33,220 444,451 0.1
Stock Strategies: Four Important Lessons
• Lesson 1: Invest in stocks for the long-run
– Stocks will have higher returns, on average
– Stock market risks are acceptable, if you have a long enough time horizon
– Question and Answer
Stock Strategies: Four Important Lessons
• Lesson 2: Free-ride on the market competition
– Most actively managed funds and brokerage accounts will under-perform index funds over the long-run
– Choose “total market” index funds
Ten-Year Annualized Return on the 30 Largest Mutual Funds Investor return for calendar years 1995 to 2004 (largest funds as of year-end 1994)
Average mutual fund return: 10.78%Vanguard 500 Index fund return: 12.00%
Funds outperforming the index: 9 out of 30 (30%)Correlation to prior decade return: -.250
1 Fidelity Magellan 10.16 16 Fidelity Growth Opportunity 6.812 Investment Company of America 13.04 17 AXP New Dimensions 10.643 Washington Mutual Investors 13.54 18 Pioneer II 8.984 Vanguard Windsor 12.81 19 American Centuary Growth 8.735 American Century Ultra 10.40 20 Lord Abbett Affiliated 12.896 Janus 9.32 21 American Century Select 9.507 Fidelity Growth and Income 11.04 22 AIM Weingarten 6.168 Fidelity Contrafund 13.82 23 Putnam Voyager 9.109 Vanguard Windsor II 13.71 24 Putnam Growth and Income B 9.94
10 Fidelity Equity-Income II 11.65 25 Fidelity Blue Chip Growth 8.8211 Fidelity Equity-Income 11.94 26 Fidelity Destiny 6.7612 MSDW Dividend Growth 9.62 27 T. Rowe Price Equity Income 13.0013 Putnam Growth and Income 10.76 28 Fidelity Independence 10.6314 American Mutual 11.93 29 Waddell & Reed 10.3715 Growth Fund of America 14.79 30 Fidelity Growth Company 12.57
Index Funds Have Low Fees
Performance comes and goes, but costs roll on forever.--Jack Bogle
Value of $100,000 investment33% of your retirement to manager
Low Fees or Low Amounts
Vanguard is a pioneer in low cost index funds (passively managed diversified mutual funds with fees oftenbelow 0.2% per year)www.vanguard.com
Homestead Funds is a pioneer in managing smallaccounts (minimum of $200 for IRA and $500 for regular accounts—NO minimum if automatic scheduled investments)homesteadfunds.com
From: “The Inefficient Markets Argument for Passive Investing"" by Steven Thorley, Marriott School working paper, 1999.
Figure 1a: Distribution of Simulated Portfolio Returns for 1996
Before Costs
0
100
200
300
400
500
600
700
800
900
1000
-20 -15 -10 -5 0 5 10 15 20 25 30 35 40 45 50
Percent Return
Por
tfol
io C
ount
Index Fund Return
From: “The Inefficient Markets Argument for Passive Investing"" by Steven Thorley, Marriott School working paper, 1999.
Figure 1b: Distribution of Simulated Portfolio Returns for 1996
After Costs
0
100
200
300
400
500
600
700
800
900
1000
-20 -15 -10 -5 0 5 10 15 20 25 30 35 40 45 50
Percent Return
Por
tfol
io C
ount
Index Fund Return
Stock Strategies: Four Important Lessons
• Lesson 2: Free-ride on the market competition– Most actively managed funds and brokerage accounts
will under-perform index funds over the long-run
– Choose “total market” index funds
– The competition in stock-market research is intense, and will get more competitive going forward
– Market indexing or “passive investing” is a free-ride on the competition
Stock Strategies: Four Important Lessons
An essential element of profitable economic activity …
- Barriers to entry (Porter’s five forces)
- Sustainable competitive advantage (Strategic Theory)
- Economic Rents (Microeconomic Theory)
- A “moat” (Warren Buffet)
Benjamin Graham on security analysis, 1976:
This was a rewarding activity, say forty years ago, when our
textbook “Graham and Dodd”was first published; but thesituation has changed a good deal since then. In light of theenormous amount of research now being carried on, I doubtwhether in most cases such extensive efforts will generatesufficiently superior selections to justify their cost.
Trouble with TimingPeriod of Investment NYSE/
AMEX/NASDAQ Return Annualized
Value of $10,000 Invested in Jan. 1985
January 2, 1985 - December 30, 2005 +12.48% $118,089
Less the 10 biggest days + 9.81% $71,389
Less the 20 biggest days +7.84% $48,827
Less the 30 biggest days +6.13% $34,854
Less the 40 biggest days +4.60% $25,695
Data Source: CRSP Value-Weighted Index with Dividends
Investment Catagories - Annual Return from 1996-20002000 1999 1998 1997 1996
Gov Bonds Tech Tech Large Caps Small Caps
10.48% 128.45% 74.81% 32.63% 24.98%
Corp. Bonds Foreign Large Caps Utilities Large Caps
9.75% 77.91% 29.91% 26.53% 24.62%
Utilities Small Caps Utilities Small Caps Foreign
7.83% 71.21% 20.69% 25.43% 20.95%
Small Caps Large Caps Foreign High Yld Bonds Tech
5.95% 28.68% 20.18% 13.35% 15.52%
Large Caps Utilities Corp. Bonds Foreign High Yld Bonds
-1.59% 22.06% 7.61% 11.05% 13.90%
High Yld Bonds High Yld Bonds Gov. Bonds Corp. Bonds Utilities
-5.03% 6.17% 6.74% 9.68% 12.17%
Foreign Gov. Bonds Small Caps Tech Gov. Bonds
-10.72% 0.75% 4.72% 9.13% 4.64%
Tech Corp. Bonds High Yld Bonds Gov. Bonds Corp. Bonds
-31.40% -0.29% 2.18% 8.78% 4.51%
S&P 500 S&P 500 S&P 500 S&P 500 S&P 500
-10.10% 19.50% 26.70% 31.00% 20.30%
Stock Strategies: Four Important Lessons
• Lesson 2: Free-ride on the market competition– Bad reasons to not index
• Passive investing is boring• War stories are fun to share with friends• Doing nothing about your portfolio is unnerving• Promotional material on indexing is lacking• Habit and tradition
– Good reasons not to index• You are stuck in funds that have a high exit cost• Index funds are unavailable in some plans and foreign markets• Legal proprietary information is routinely available to you• In taxable accounts, complex tax/donation strategies are possible
– Reason to index• Superior long-run performance
Stock Strategies: Four Important Lessons
• Lesson 2: Free-ride on the market competition
– Indexing alternatives• Mutual Funds (Vanguard, Fidelity, etc.)
– Easy, no trading costs (commissions or bid/ask spread)
• Exchange Traded Funds (SPDRs, WEBs now iShares)– Slightly lower management costs– Potential better tax effects
– Trading throughout the day (ouch!)
Stock Strategies: Four Important Lessons
• Lesson 2: Free-ride on the market competition
– Question and Answer
Stock Strategies: Four Important Lessons
• Lesson 3: Avoid the hidden price tags of trading– Transaction costs
• Brokerage commissions
• Bid-ask spread
– Risk• Indexing is optimal diversification
• Active funds are more volatile than the market as a whole
– Taxes• Income taxes are triggered by buy and sell transactions
– Time and energy• Beating the market requires a lot of both
Internal Revenue Service
Publication 586A
The Collection Process
(Income Tax Accounts)
Stock Strategies: Four Important Lessons
• Grant’s day-trading buddy
– $500,000 in stocks X 2% $10,000
– 250 days X 1 trade X $15 - 3,750
– $0.125 X 100 shares X 250 trades - 3,125
– Gross Trading Profit 3,125
– Tax @ 39.6% - 1,237
– Net Profit $ 1,888
Stock Strategies: Four Important Lessons
• Grant’s day-trading buddy
– Trading Profit $1,888
– 10 hours/week X 52 weeks 520 hours
– Equals $3.63 per hour!
– Not to mention the costs of an office, computer, internet fee, real time data fee, and …
…THE FACT THAT HE DIDN’T BEAT THE MARKET.
From: “Does the ‘Dow-10 Investment Strategy’ Beat the Dow Statistically and Economically?”by Grant McQueen, Kay Shields, and Steven Thorley, Financial Analysts Journal, Vol. 53, No.4, pp. 66-72 (July/August 1997).
Table 2: Annual Mean Percentage Returns and Standard Deviationsfor the Dow-10 and Dow-30 Portfolios, 10-year Subperiod Analysis
Subperiod Dow-10 Dow-30Nominal
Difference
RiskAdjusted
Difference
Risk andTransaction Cost
Adjusted Difference
1946-1955 20.28(25.39)
17.34(17.37)
2.94 -3.11 -3.61
1956-1965 13.97(17.42)
13.21(15.83)
0.76 -0.25 -0.78
1966-1975 10.36(22.19)
5.81(20.22)
4.54 4.12 3.44
1976-1985 19.29(14.55)
14.45(16.95)
4.84 6.52 5.93
1986-1995 19.95(15.74)
17.73(12.50)
2.23 -0.74 -1.22
Stock Strategies: Four Important Lessons
• Lesson 3: Avoid the hidden price tags of trading
– Question and Answer
Stock Strategies: Four Important Lessons
• Lesson 4: Don’t fall into the data mine
– Intra-generational
The S&P 5001983-1993
S&
P 5
00
YearSource for all the S&P 500 data mining graphs is: David Leinweber’s “Data-Snooping Biases in Tests of Financial Asset Pricing Models.”
Overfitting the S&P 500Butter in Bangladesh
R2=.75
S&
P 5
00
Year
Overfitting the S&P 500Butter Production in Bangladesh and the United States
R2=.95
S&
P 5
00
Year
Overfitting the S&P 500Butter Production in Bangladesh and the United States
United States Cheese ProductionSheep Population in Bangladesh and the United States
R2=.99
S&
P 5
00
Year
Polynomial Fit to the S&P 500Big Mistake or Bad Idea?
S&
P 5
00
Year
.25 1016 - .26 1013 y + .12 1010 y2 - 32000 y3 + 56 y4 - .0064 y5 + .49 10-6 y6 - .24 10-10 y7 + .69 10-15 y8 - .88 10-20 y9
Polynomial Fit to the S&P 500Big Mistake or Bad Idea?
S&
P 5
00
Year
.77 1017 - .88 1014 y + .45 1011 y2 - .14 108 y3 + 2700 y4 - .37 y5 + .000035 y6 - .23 10-8 y7 + .99 10-13 y8 - .25 10-17 y9 + .28 10-22 y10
Stock Strategies: Four Important Lessons
• Lesson 4: Don’t fall into the data mine– Intra-generational
– Inter-generational
• No story/no future
From: “Mining Fool’s Gold” by Grant McQueen and Steven Thorley, Financial Analysts Journal, Vol. 55,No. 2, pp. 61-72 (March/April 1999).
Table 1: Summary Statistics for Various Dow Dividend Portfolios, 1973 to 1996
Dow 30Dow
Dividend Dow Five Dow Four Foolish
FourFractured
Four
Average 15.80 20.31 23.40 26.41 28.03 34.82
StandardDeviation
17.29 16.50 20.69 22.78 26.97 44.50
Dow 30 is an equally-weighted portfolio of all 30 stocks in the Dow Jones Industrial Average (DJIA).Dow Dividend is an equally-weighted portfolio of the ten DJIA stocks with the highest dividend yield.Dow Five is an equally-weighted portfolio of the five lowest-priced stocks in the Dow Dividend Portfolio.Dow Four is an equally-weighted portfolio of the four highest-priced Dow Five stocks.Foolish Four is a portfolio of the Dow Four stocks with 20 percent weight on the three highest-priced
stocks and 40 percent weight on the lowest-priced stock.Fractured Four is the Dow Four in even years and the “penultimate profit prospect” in odd years.
Stock Strategies: Four Important Lessons
• Lesson 4: Don’t fall into the data mine– Intra-generational
– Inter-generational
• No story/no future
• Out-of-sample testing
From: Investment Strategy Claims: Don’t Fall into the Data Mine, AAII Journal, Feb. 2000, by McQueen and Thorley
Dow 30 Foolish 4.0 In-sample (73-93) 14.8% 28.8% Out-of-sample (July rebal.) 17.4% 18.9%Out-of-sample (52-72) 12.7% 11.9%Out-of-sample (Twins) 13.9% 14.9%Out-of-sample (since the book) 1994 3.9% -6.1% 1995 37.6% 40.1% 1996 26.1% 37.3% 1997 22.4% 28.1% 1998 16.9% 17.0% 1999 15.8% -8.0%
2000 Opps!
Stock Strategies: Four Important Lessons
• Lesson 4: Don’t fall into the data mine– Intra-generational
– Inter-generational
• No story/no future
• Out-of-sample testing
• Front runners
0
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3
4
5
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7
-15 -10 -5 0 5 10 15
Event Day
Cum
ulat
ive
Exc
ess
Ret
urn
(%)
Figure 1. Foolish Four Event Study, 1994-97
From: “Mining Fool’s Gold” by Grant McQueen and Steven Thorley, Financial Analysts Journal, Vol. 55, No. 2, pp. 61-72, (March/April 1999).
Stock Strategies: Four Important Lessons
• Lesson 4: Don’t fall into the data mine
– Question and Answer
Stock Investment Strategies for Individuals:Four Important Lessons
• Lesson 1: Invest in stocks for the long-run
• Lesson 2: Free-ride on the market competition
• Lesson 3: Avoid the hidden price-tags of trading
• Lesson 4: Don’t fall into the data-mine
Stock Strategies: Four Important Lessons
• Final Question and Answer
Stock Market Investing for the 21st Century:A Review and Update
• “For the love of money is the root of all evil …” 1st Timothy 6:10
• “But before ye seek for riches, seek ye first the kingdom of God” Jacob 2:18