How to Double Your Money

Stop whatever you’re doing and do the following equation in your mind. No calculators, okay:

5 + 5 + 5 + 5 + 5

Got it? Great. Now do the following equation in your mind:

5 x 5 x 5 x 5 x 5

Not as easy is it? Why?

As human beings we underestimate the power of small numbers and the impact they can have when added together – we underestimate the power of compounding. Because it isn’t intuitive we ignore it and try and solve the problem through other means.

The compounding of investments is such a powerful thing. Even the average investor can double their money in the stock market, time and time again – that’s if they stick with their stocks over the long run. One of my favourite bloggers, Josh Brown AKA The Reformed Broker recently hit the streets to help people wrap their heads around exponential growth and real wealth building. Here’s the video – watch it.

Source: CNBC

If the link doesn’t work, click here.

Time can be a better friend to investors than experience, connections, expertise, or even research. And yet so few people seem to have a good grasp of the power of compounding.

By the way, the answer to the above equation is 3,125. But hey, you knew that right?

My Monday Rant

Last week I copped a bit of criticism following my Safe As Houses post. Here’s the first:

2 major flaws in your chart, which would suggest your post is indeed ‘enticing narrative’; – If you factored in the income from each of these assets, including the fully franked dividend from the CBA, you would find the CBA has delivered somewhere around 200% of the income return of property – What is the impact if you took said income and reinvested it? Massive… I’d love to see your chart then. Capital Growth is only one component of your return and in the case of the CBA, represents around half your return.

This reader raises a valid point – dividends and the impact and power of compounding returns. I decided to ‘tidy up’ my analysis. So I included CBA’s dividend, reinvested it (although not everyone reinvests dividends), and compared the return to Melbourne and Sydney house prices in nominal terms. I chose Melbourne and Sydney given the share of CBA’s loan book these two cities.

And voilà, here’s what we have. Although I didn’t have time to incorporate rental income from the two cities, the outcome is no different. I also note the chart is not a common base chart, i.e. all investments start at the same point, which means Melbourne’s end price would be higher given the lower start price.

You can see the correlation and behaviour is very similar. Another reader writes:

With two sides of the story being capital growth and income received I don’t think you have provided great understanding of the correlations and drivers of both property & shares and underrepresented both.

My original article was providing evidence of the correlation between residential property and CBA’s share price, and was being done so not based on the two being mutually exclusive.

The reader continues…

Families need to understand whether they want to have a part time job, maintaining a property portfolio, chasing rent, keeping tenants, fixing broken water pipes, paying real estate agents, paying lawyers. Or whether they would like a set and forget strategy of investing in the great companies of this world, where they pay a financial adviser, a platform and investment fee and they can enjoy what’s most important to them.

Although the reader seems to have misunderstood the intent of my original article, they raise a valid point. Investing in direct property can be both time consuming and costly. For this reason, most investors hire a real estate agent. They take care of the maintenance of the property, they both find and keep tenants, they arrange for the broker water pipes to be fixed, and yes, we pay them a fee. Just like our clients pay us for the services we provide. I would have also thought that property can be a ‘set and forget’ investment too, can it not?

The alternative the reader provides us with is to hire a financial adviser, pay them, hire a platform, and pay them, then pay the investment fees, and forget all about it.

I admit, my comments are tongue in cheek, but what these comments proved to me, yet again, is that those with vested interest will continue to peddle the narrative that best suits them. Walk into a Holden dealership, you won’t be sold a Toyota.

Investors deserve the truth. Investors deserve to be educated. Investors deserve the right to know what we as advisers can help them with and cannot help them with, not what we will and will not help them with – there is a difference.

My original article was not to spark debate between property or shares. Both asset classes not only behave very differently, they both serve different objectives. History tells us that both Australian shares and Australian residential property have performed broadly in line with each other over the long-term. Australian shares have provided a slightly higher rate of return, however Australian residential property has provided investors with a smoother ride along the way.

Source: AMP

I kindly remind you, as investors, look beneath the investment and ask yourself the following questions:

  1. Where am I allocating my money?
  2. What is the underlying investment?
  3. What is the investment influenced by?
  4. What am I really investing in?

Most importantly, ask yourself this question:

What is the objective/purpose of my investment?

Here’s the blueprint for how to think about investing in it’s simplest form – a snippet from our Intergenerational Wealth Transfer forum in 2018.

God speed.

Here’s What Michael Jordan And The Stock Market Have in Common

“Look at the air, look at the hang time, look at the flying motion”

The debate is an ongoing one. Michael Jordan or LeBron James, who is the greatest player that ever lived. For me, it’s Michael – hands down. Sure, I’m biased – I grew up in the 80’s. The shoes, the jersey, the shorts, the posters – I was obsessed with him. Watching highlights of MJ now gives me goosebumps each and every time. His skill, his talent, his style, his accuracy, his precision, that air time would have not only the supporters in the stands up on their feet, but also the game’s commentators.

He was an absolute sniper with that ball in his hands. Leave him open for a split second, and he’ll put that thing away before you even had a chance to work out what happened.

Michael leads the NBA All-Time Points table with an average of 30.12 points per game. Quite impressive. But MJ’s scores per game were no where near his average. With the data that’s available, I have crunched the numbers. I looked at each game Jordan played and took the points he scored during that game. I was able to get my hands on 868 game data (Jordan played 1,072 games). I then calculated how many times Jordan scored 30 points in a game. The number is 35. Michael Jordan scored 30 points per game, 35 times in his career. In other words, 4.03% of the time he scored his average points.

Each blue dot in the chat below represents one game, and the red horizontal line represents an average of 30 points. You can see the range of scores that are well below and well above his average.

Data: www.landofbasketball.com

The Australian stock market has delivered an average annual return of around 13% since 1980. But short-term results may vary, and in any given period stock returns can be positive, negative, or flat. When setting your expectations, it’s helpful to see the range of outcomes experienced by investors historically. For example, how often have the stock market’s annual returns actually aligned with its long-term average?

The chart below shows calendar year returns for the S&P/ASX 300 Index (Total Return) since 1980. The shaded band marks the historical average of 12.94%, plus or minus 2 percentage points. The S&P/ASX 300 Index had a return within this range in only four of the past 39 calendar years. In most years, the index’s return was outside of the range—often above or below by a wide margin—with no obvious pattern. For investors, the data highlight the importance of looking beyond average returns and being aware of the range of potential outcomes.

Source: DFA

Despite the year-to-year volatility, investors can potentially increase their chances of having a positive outcome by maintaining a long-term focus. The chart below documents the historical frequency of positive returns over rolling periods of one, five, and 10 years in the Australian market. The data show that, while positive performance is never assured, investors’ odds improve over longer time horizons.

Source: DFA

While some investors might find it easy to stay the course in years with above average returns, periods of disappointing results may test an investor’s faith in equity markets. Being aware of the range of potential outcomes can help investors remain disciplined, which in the long term can increase the odds of a successful investment experience. What can help investors endure the ups and downs? While there is no silver bullet, understanding how markets work and trusting market prices are good starting points. An asset allocation that aligns with personal risk tolerances and investment goals is also valuable. By thoughtfully considering these and other issues, investors may be better prepared to stay focused on their long-term goals during different market environments.

As you wouldn’t bench Michael when he’s scoring 15 points per game, investors shouldn’t be benching their investment strategy when returns are looking below average. If you’re not playing the game, you’re not scoring the points.

“There’s Michael Jordan and then there is the rest of us.”

— Magic Johnson

Take the long-view. Thanks for the memories Michael.

Winter is Coming. Avoid These Mistakes.

It was over 150 years ago Admiral Robert FitzRoy took his own life. Today FitzRoy is primarily remembered as the captail of HMS Beagle during Charles Darwin’s famous voyage in the 1830. However, during his lifetime FitzRoy found celebrity not from his time at sea but from his pioneering daily weather predictions, which he called by a new name of his own invention – “forecasts”.

Discovering how seasons worked, and understanding that winter came around once a year, has helped humans thrive for centuries.

Financial markets, not dissimilar to the weather, goes through patterns. And winter, is a harsh season for both. The current bull market has been running for over 10 years now, making it one of the longest in history. As summer doesn’t last forever, neither do bull markets. By understanding how the seasons of financial markets work will give you an enormous edge over the average investor.

The only value of stock forecasters is to make fortune-tellers look good.

– Warren Buffett

Here are 7 facts you need to understand and remember about the stock market.

Fact #1: On average, corrections happen once per year

For more than a century, the market has seen close to one correction (a decline of 10% or more) per year. In other words, corrections are a regular part of financial seasons – and you can expect to see as many corrections as birthdays throughout your life.

The average correction looks something like this:

  • 54 days long
  • 13.5% market decline
  • Occurs once per year

The uncertainty of a correction can prompt people to make big mistakes – but in reality, most corrections are over before you know it. If you hold on tight, it’s likely the storm will pass.

Fact #2: Fewer than 20% of all corrections turn into a bear market

When the stock market starts tumbling, it can be tempting to abandon ship by selling assets and moving into cash. However, doing so could be a big mistake.

You would likely be selling all of your assets at a low, right before the market rebounds!

Why? Fewer than 20% of corrections turn into bear markets. Put another way, 80% of corrections are just short breaks in otherwise intact bull markets – meaning that selling early would make you miss the rest of the upward trend.

Fact #3: Nobody can predict consistently whether the market will rise or fall

The media perpetuates a myth that, if you’re smart enough, you can predict the market’s moves and avoid its downdrafts.

But the reality is: no one can time the market.

During the current nine year bull market, there have been dozens of calls for stock market crashes from even very seasoned investors. None of these calls have come true, and if you’d have listened to these experts, you would have missed the upside.

The best opportunities come in times of maximum pessimism.

– John Templeton

Fact #4: The market has always risen, despite short-term setbacks

Market drops are a very regular occurrence. For example, the S&P 500 – the main index that tracks the U.S. stock market – has fallen on average 14.2% at least one point each year between 1980-2015.

Like winter, these drops are a part of the market’s seasons. Over this same period of time, despite these temporary drops, the market ended up achieving a positive return 27 of 36 years. That’s 75% of the time!

Fact #5: Historically, bear markets have happened every three to five years

In the 115 year span between 1900-2015, there have been 34 bear markets.

But bear markets don’t last. Over that timeframe, they’ve varied in length from 45 days to 694 days, but on average they lasted about a year.

Fact #6: Bear markets become bull markets

Do you remember how fragile the world seemed in 2008 when banks were collapsing and the stock market was in free fall?

When you pictured the future, did it seem dark and dangerous? Or did it seem like the good times were just around the corner and the party was about to begin?

The fact is, once a bear market ends, the following 12 months can see crucial market gains.

Fact #7: The greatest danger is being out of the market

From 1996 through 2015, the S&P 500 returned an average of 8.2% a year.

But if you missed out on the top 10 trading days during that period, your returns dwindled to just 4.5% a year.

It gets worse! If you missed out on the top 20 trading days, your returns were just 2.1%.

And if you missed out on the top 30 trading days? Your returns vanished into thin air, falling all the way to zero!

You can’t win by sitting on the bench. You have to be in the game. To put it another way, fear isn’t rewarded. Courage is.

– Tony Robbins

Source: Visual Capitalist, Tony Robbins, Peter Mallouk, S&P

25 Things You Probably Know & Don’t Know About Investing

If you are ready to give up everything else and study the whole history and background of the market and all principal companies whose stocks are on the board as carefully as a medical student studies anatomy – if you can do all that and in addition you have the cool nerves of a gambler, the sixth sense of a clairvoyant and the courage of a lion, you have a ghost of a chance.

– Bernard Baruch

Making money in the modern market is tough. As investors, there are so many things we think we know, yet very few spend time thinking about the things they don’t know. Jim O’Shaughnessy, founder, Chairman, and CIO of O’Shaughnessy Asset Management recently shared what he thinks he knows and doesn’t know about the financial markets. I think investors should take note. Here they are:

  1. I don’t know how the market will perform this year. I don’t know how the market will perform next year. I don’t know if stocks will be higher or lower in five years. Indeed, even though the probabilities favor a positive outcome, I don’t know if stocks will be higher in 10 yrs.
  2. I DO know that, according to Forbes, “since 1945…there have been 77 market drops between 5% and 10%…and 27 corrections between 10% and 20%” I know that market corrections are a feature, not a bug, required to get good long-term performance.
  3. I do know that during these corrections, there will be a host of “experts” on business TV, blogs, magazines, podcasts and radio warning investors that THIS is the big one. That stocks are heading dramatically lower, and that they should get out now, while they still can.
  4. I know that given the way we are constructed, many investors will react emotionally and heed these warnings and sell their holdings, saying they will “wait until the smoke clears” before they return to the market.
  5. I know that over time, most of these investors will not return to the market until well after the bottom, usually when stocks have already dramatically increased in value.
  6. I think I know that, at least for U.S. investors, no matter how much stocks drop, they will always come back and make new highs. That’s been the story in America since the late 1700s.
  7. I think I know that this cycle will repeat itself, with variations, for the rest of my life, and probably for my children’s and grandchildren’s lives as well.
  8. Massive amounts of data have documented that while the world is very chaotic, the way humans respond to things is fairly predictable.
  9. I don’t know if some incredible jump in evolution or intervention based upon new discoveries will change human nature but would gladly make a long-term bet that such a thing will not happen.
  10. I don’t know what exciting new industries and companies will capture investor’s attention over the next 20 years, but I think I know that investors will get very excited by them and price them to perfection.
  11. I do know that perfection is a very high hurdle that most of these innovative companies will be unable to achieve.
  12. I think I know that they will suffer the same fate as the most exciting and innovative companies of the past and that most will crash and burn.
  13. I infer this because “about 3,000 automobile companies have existed in the United States”, and that of the remaining 3, one was bailed out, one was bought out and only one is still chugging along on its own.
  14. I know that, as a professional investor, if my goal is to do better than the market, my investment portfolio must look very different than the market. I know that, in the short-term, the odds are against me but I think I know that in the long-term, they are in my favor.
  15. I do know that by staking my claim on portfolios that are very different than the market, I have, and will continue to have, far higher career risk than other professionals, especially those with a low tracking error target.
  16. I know that I can not tell you which individual stocks I’m buying today will be responsible for my portfolio’s overall performance. I also know that trying to guess which ones will be the best performers almost always results in guessing the wrong way.
  17. I know that as a systematic, rules-based quantitative investor, I can negate my entire track record by just once emotionally overriding my investment models, as many sadly did during the financial crisis.
  18. I think I know that no matter how many times you “prove” that we are saddled with a host of behavioral biases that make successful long-term investing an odds-against bet, many people will say they understand but continue to exhibit the biases.
  19. I think I know the reason for the persistence of these “cognitive mirages” is that up to 45% of our investment choices are determined by genetics and can not be educated against.
  20. I think I know that if I didn’t adhere to an entirely quantitative investment mythology, I would be as likely—maybe MORE likely—to giving into all these behavioral biases.
  21. I know I don’t know exactly how much of my success is due to luck and how much is due to skill. I do know that luck definitely played, and will continue to play, a fairly substantial role.
  22. I don’t know how the majority of investors who are indexing their portfolios will react to a bear market. I think I know that they will react badly and sell out of their indexed portfolio near a market bottom.
  23. I think I know that the majority of active stock market investors—both professional and aficionado—will secretly believe that while these human foibles that make investing hard apply to others, they don’t apply to them.
  24. I know they apply to me and to everyone who works for me.
  25. Finally, while I think I know that everything I’ve just said is correct, the fact is I can’t know that with certainty and that if history has taught us anything, it’s that the majority of things we currently believe are wrong.

What is it about investing and financial markets that you don’t know?

Visualising The Damage on The Stock Market

Bed goes up, bed goes down, bed goes up, bed goes down.

– Homer Simpson

Since the GFC stocks have been the perfect place to hide. In fact, there has been no safer bet with stock markets around the world trading at multiples of their GFC lows. Here’s how major stock markets around the world performed (total return) since the bottom of the GFC:

(orange line – Australia, purple line – Asia, green line – Europe, blue line – US, red – Emerging Markets)

Only when the tide goes out do you discover who’s been swimming naked.

– Warren Buffett

Financial markets however, have no regard for what you want or what you need, and will turn on you like the Melbourne weather leaving you perplexed as to which season it is.

The recent spasm of news coverage on the stock market correction prompted me to assess the damage done on stocks. For the last two months, these were the headlines investors have been reading – how exciting!

I’m not sure who defined a market correction being a decline of 10% or more, but it’s the widely accepted definition. What good is it for investors to know that the correction has begun based on some meaningless threshold someone fabricated? Why is the threshold not 12%, or 15%? Why should a manufactured definition trigger investors to revisit their investment strategy? To me, this threshold seems illogical, and to base investment decisions on these definitions seems foolish.

Let’s take a look at what all the fuss is about. Here’s a chart showing the total return of the above indices since 8 October (when the decline began) to Friday, 23 November 2018:

Within two months, the US stock market is down 10.69%, Europe is down 9.05%, Asia down 7.97%, Australia down 5.92%, and Emerging Markets down 5.25%. Having said this, if we were to look at peak to trough using 52 week highs, the chart above would look different again. In fact, Emerging Markets would look a lot worse if we pulled the start date back to earlier on in the year. It doesn’t matter where you were invested your money, there really was nowhere to hide.

If you think that’s bad, just spare a moment for the tech investors. Here are the FAANGs (Facebook, Apple, Amazon, Netflix, Google) against the S&P500 (orange line) and Nasdaq (grey line):

(purple line – Facebook, green line – Amazon, blue line – Apple, yellow line – Google)

Hey, what do you expect after a run up like this:

Netflix’s market cap is currently sitting at US$112 billion. To put that into perspective, Citigroup is currently valued at US$150 billion. Number of employees at each company: Citigroup – 209,000, Netflix – 5,400. Revenue (2018 est): Citigroup – US$216,000,000, Netflix – US$16 billion. Net income (2018 est): Citigroup – US$18 billion, Netflix US$671 million.

Markets can remain irrational for a lot longer than you and I can remain solvent.

– John Maynard Keynes

Most money managers will highlight and emphasize performance for a select period of time (I’ll let you decide why), so it’s very useful to me (and investors) to look at things through a wider lens. So here it goes – the recent market declines since the GFC for stock markets around the world:

It comes as no surprise that the asset class that has performed the best over the last 10 years is the one that has fallen the most when things are seem a little uncertain.

Even following a market “correction”, the US stock market is still up 265%, the Australian market up 144%, and Asia, Europe, and Emerging Markets up 123%, 80%, and 59% respectively.

There are several narratives that are making headlines justifying the recent market decline. The general theme goes something like this: This bull market has been running hot for almost 10 years. Interest rates are rising, and cost pressures are rising, which will cause inflation. Whatever narrative you decide makes most sense to you, the reality is that the news that is floating around is not new and is probably priced into current market valuations anyway.

At the end of the day, the more you pay for an asset, the less the future expected return. The less you pay for an asset, the greater the future expected return. In life, and in financial markets, things sometimes just don’t make any sense – although they eventually do. Don’t try and keep up with the Jones’ or get caught up in the market and media hype – it takes guts, discipline, patience and time to make money.

When you decide to embark on the journey of investing, remember the wise words of Homer Simpson – bed goes up, bed goes down.

Source:

  • Charts and headlines – Thomson Reuters
  • Returns are denominated in AUD for all charts except the FAANGs

You’re Being Fooled Into Overpaying For Underperformance – Here’s How

When people ask me what I do, I tell them I’m in the business of helping people make money. The business we’re really in though, is helping improve the lives of our clients. It comes from the belief that life is about more than money. I believe money is an enabler – it provides us with options, choice, and flexibility. So if we can help our clients preserve and build their financial wealth, we can help them live a more meaningful and fulfilled life – a life that is truly rich.

Sadly, most people never achieve a life that is truly meaningful and fulfilling – true wealth. Why? Because they’re focused on the scoreboard, and not the process. They’re focused on chasing the money.

Enter the world of investments, stock brokers, financial advisers, fund managers, and high flying financial institutions. If you’re not careful, you might be sailing toward financial freedom with a hole in the bottom of your boat. That hole, is in fact lining the pockets of those purporting to be helping you sail toward the sunset.

When was the last time you looked at your superannuation or investment portfolio statement? Your portfolio has probably grown, especially over the last ten years, so you haven’t taken too much notice. The real question is, how much have you left on the table?

Australians have around $2 trillion sitting in superannuation, which has attracted fund managers like bees around a honey pot. And Australian are paying some of the highest fees for the management and oversight of this money. In fact, last year, Australian’s paid $31 billion in superannuation fees – totaling around $230 billion in the last decade.

So what can you do about it? Here are three things to consider:

1. Fund Fees

When it comes to truly understanding the cost of your investments, it’s hard enough for the professionals to do, let alone the general public. There are many hidden costs that lie beneath the surface – here they are (average):

1. Expense ratio – 0.90% pa

This covers marketing and distribution cost, as well as the management of the portfolio. Typically, this is the only fee investors are aware of.

2. Transaction costs – 1.44% pa

Typically investment managers buy and sell frequently. And with these transactions comes transaction fees. There are three types of transaction costs: 1) brokerage, 2) market impact, and 3) spread.

3. Cash drag – 0.83% pa

This is the portion of your portfolio that is invested in cash. It hurts your return over the long-term because of the missed opportunities in the market.

5. Taxes – 1.00% pa

When you by into a fund, sometimes you’re being taxed for other investors’ gains.

The total of these fees can be as high as 4.17% pa. Although on face value these fees don’t seem high at all, when you compound these costs over long periods of time, it will blow your mind. The above list didn’t even include performance fees!

Here’s what happens when you invest $100,000 into the market with a 7% pa return. The compounding value over 50 years is almost $3,000,000! Let’s start deducting some fees from this return – here’s what you’re left with when you take 1% and 2% in fees:

Even a small number like 2%, compounded over a long period of time, can lead to financial ruin. Jack Bogle, the founder of Vanguard once said:

You put up 100% of the capital, you took 100% of the risk, and you got 33% of the return!

2. Chasing Performance

Forget fees. Just invest in the top performing funds, or sell before the market falls and buy before the market rises (market timing). Easier said that done.

A) Chasing the top performers

Over the last 15 years, almost 80% of all Australian fund managers have failed to beat the broad Australian share index. And after 15 years, only 56% of Australian find managers survived.

Over the last 15 years, almost 90% of all international fund managers failed to beat the broad international share index. And after 15 years, only 46% of international fund managers survived.

B) Timing the market

Researchers Richard Bauer and Julie Dahlquist examined more than a million market-timing sequences from 1926 to 1999. Their research concluded that by just holding the broad market index outperformed more than 80% of market-timing strategies.

Clearly, neither of these strategies put the odds firmly in your favour. In fact, they’re akin to gambling more than anything. Making money in the markets is tough. So if you can’t beat the market by hiring the best, what to the the real experts recommend you do?

3. The Advice

Making money in the markets is tough. The brilliant trader and investor Bernard Baruch put it well when he said:

If you are ready to give up everything else and study the whole industry and background of the market and all principal companies whose stocks are on the board as carefully as a medical student studies anatomy – if you can do all that and in addition you have the cool nerves of a gambler, the sixth sense of a clairvoyant and the courage of a lion, you have a ghost of a chance.

Jack Bogle says understand that what appears to be success in financial markets could just be dumb luck:

If you pack 1,024 gorillas in a gymnasium and teach them each to flip a coin, one of them will flip heads ten times in a row. Most would call that luck, but when it happens in the fund business, we call him a genius!

Warren Buffett wrote this in his 2013 letter to Berkshire Hathaway shareholders:

My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee managers

He even made a bet in 2008 and put his money where his mouth was. You can read my note about it here.

It’s super important to know that not all costs are bad. The right financial adviser can help you make better decisions over the long-term to save you money. Vanguard recently published a study to help quantify the value of a good adviser.

1. Suitable asset allocation – 0.75% pa

2. Cost effective implementation – 0.70% pa

3. Rebalancing portfolio – 0.37% pa

4. Behavioural coaching – 1.50% pa

Total – 3.32% pa of value added

This does not include any other benefits or value of a good financial adviser, such as strategic and structural advice. Compound that and see what your portfolio looks like.

Next time you pick up your investment portfolio statement, think twice about what you’re doing. Are you 100% sure the financial odds are firmly in your favour? Fees are the silent killer in your portfolio, and only a handful of funds beat the market consistently and over the long-term, and much of this can be attributed to randomness.

Being in the market, while minimising costs, can empower you to getting the real financial freedom you deserve.

Source: Forbes – The real cost of owning a mutual fund 2011, Visual Capitalist, Vanguard, SPIVA, Berkshire Hathaway Shareholder Letter 2013

A Bear Market is Just Around The Corner (or is it?)

You’d be totally forgiven for thinking no more of what a bad economy and market looks and feels like. I mean, how could you not?

Consumer confidence is the highest it’s been for a number of years, and well ahead of GFC lows:

Australia Consumer Confidence

We’re spending more:

Australia Consumer Spending

We’re saving less:

Australia Household Saving Ratio

We’re earning more money since the GFC:

Australia Average Weekly Wages

And of course, the stock market…say no more:

World stock markets continue to make all time highs. The current bull market (as defined as a 20%+ increase in the market) has lasted 3,255 days, which in fact is the second longest on record behind the 4,494 day bull market that ran from late 1987 through to the early 2000. The market climbed 13 years without a single decline of 20% or more.

If this bull market was going to topple the record of the 1987 bull market, we’d see our stock market continue to climb until the 19th of June 2021. Hard to imagine right? It’s not as if it hasn’t happened before!

Here’s a chart of both bull and bear markets since 1926. It shows the number of days both bull and bear markets have lasted. A couple of things to note: 1) Bull markets last longer than bear markets (I mean, a lot longer!) – the average bull market has lasted 981 days, and the average bear market has lasted 296 days, and 2) Bull/bear market cycles have been lasting longer since WW2.

Source: BIG

Let’s dig a little deeper into the post WW2 period. The chart below shows all the bull (in green) and bear (in red) markets, when they started, ended, the percentage change, and number of days they lasted. The average bull market was up 152.4% and lasted 1,651 days, with the average bear market falling 31.8% and lasting 362 days.

Source: BIG

Meanwhile, pundits have been calling for the mark top since 2012. I want you to read these comments, seriously, read them. And next time you hear or see another attention grabbing headline about the market, I want you to recall this post. Here’s a summary of the commentary since (click for larger image):

Market All Time Highs (ATH) doesn’t necessarily mean the market will crash. Here are the number of ATHs each year since 1929. The year 1995 set the record with 77 ATHs, 1964 recording 65, and 2017 notching up 62. The year 2017 is sitting in third place with the number of ATHs in any given year. Presently, the year 2018 is in 27th place, with four months to go in the year – anything could happen.

No one knows how long this market will continue to run hot. No one knows when the market will collapse either.

What you can and should do however, is design your portfolio as if the market will collapse tomorrow. Because someday, maybe sooner rather than later, the market will collapse tomorrow. And you will exhibit precisely the same behaviour as you did in 2008. You will have forgotten how you behaved, however you will remember exactly how it felt. Your human mind will switch to ‘fight-or-flight’ mode, and you will either destroy a lifetime of savings, or you could create a lifetime of savings – the choice is yours.

As long as the music keeps playing, we’ll all continue to dance, until it stops.

The Most Expensive Game of Golf You’ve Ever Played

Last week I wrote an article on investing following a speeding infringement. I received quite a number of positive responses to this note – thank you. I also received a number of questions on the concept I talked about in my blog, that is, compound interest and market timing. I touched on this topic a little while back, but let me give it another go.

Have you ever played golf and placed a bet on each hole? You know, everyone places a small amount of money on each hole, and the winner on each hole takes the lot? Pretty simple, and a bit of fun. Have you ever played this game whilst doubling the amount of money you bet on each hole? Not a big deal…start with 10 cents a hole, and double this amount for 18 holes. Any idea what the number is on the 18th hole? Before reading any further, just take a guess, quickly, don’t take too long!

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$13,107.20! Ridiculous, right!?

How on earth does this happen I hear you ask? Here’s the above table in a chart.

Notice how nothing happens for a long time, the all of a sudden, BOOM, the amount explodes. This my friends is compound investing – the eighth wonder of the world.

If you think that all you need to know is which way the stock market is going in order to make money, think again. Talk to any successful business owner or investor, it’s more about being disciplined, having a game plan, and taking the long view.

Meet John – he’s the world’s greatest stock picker. He only buys when the stock market index is trading at 52-week lows, and assuming they are 17% below his last purchase. Meet Jane – she’s the world’s worst stock picker. She invests $2,000 only at market peaks beginning in 1970, when she’s 22 years of age. She increases her investment by $2,000 per decade – $4,000 per year during the 80’s, $6,000 a year during the 90’s etc. She retires at age 65.

The results? Hands down winner is John, right? The results of this experiment (thanks to Ben Carlson) may surprise you. John does quite well, as you would expect. But the results are very similar. You’d think John’s portfolio would be multiples of Jane’s as he was buying at market lows, and Jane at market highs, however this is not the case. Why? Compound interest.

Jump on any online calculator and calculate the capitalised interest on a 30 year loan. It’s okay, I’ve done for you. A $500,000 loan, with an interest rate of 5%, accumulates interest of $966,279.60. Think about that for a second – that’s only the interest. Imagine compounding capital and interest on your stock investment! The reason John misses out on the benefit of compounding, is because he’s out of the market for long periods of time. Carlson clearly states in his analysis, “Short-term moves in and out of the market don’t matter nearly as much if you have a long-time horizon. Thinking long-term increases your probability for success in the stock market while the day-to-day noise gets drowned out by discipline and compound interest.”

The strategy is so simple, requires no insight into the future, yet it is so powerful, and actually exists – unlike the perfect market timer. The catch? It takes a long time, and it’s b-o-r-i-n-g! The irony is however, that the group of people who have the greatest capacity to absorb the market’s volatility, are the same group of people who seem to be the least interested in it.

Probabilities Versus Predictions

Last week, South Korea stunned the football world by knocking out World Cup favourites Germany. In an astonishing finish, South Korea kicked two goals within minutes of the final whistle during extra time, in one of the biggest upsets in the sport’s history. Why? Because Germany were expected to take out the 2018 Fifa World Cup.

Here’s the 2 minute wrap up of the match courtesy of SBS:

It wasn’t only the football world who expected the German’s to take the cup home, it was also the expectation of UBS’ analytical team who ran complicated statistical models to place probabilities on all nations competing in the World Cup. Here’s the report if you’re curious.

Following Germany’s loss to South Korea, UBS have been copping criticism from journalists and social media trolls, about their inability to predict or forecast the future. Individuals’ and companies’ inability to forecast the future is well documented and certainly not news to anyone that studies the market, no matter how sophisticated they are or their technology is.

Let’s get one thing clear, UBS nor any of the other investment banks “predicted” Germany would win the World Cup. They simply applied a 24% probability of winning, in other words, a 76% probability of not winning – there is a huge difference.

“We are humble enough not to outright claim that Germany will win the tournament again, but our simulations indicate there is no other team with higher odds to lift the trophy than the defending champion.” – UBS (emphasis mine)

As nerdy and as absurd as this analysis may seem, what else do you have to rely on? Your gut feel? The tip your taxi driver gave you? Your “expert” football mate? I’ll take the odds thank you very much.

This is exactly how casino’s work. Their gaming systems are all designed to ensure the odds are firmly in their favour. Sure, you may win, and you may even win big, which is why you keep playing – but the odds are slim. And if you keep playing for long enough, you will eventually lose.

And when it comes to investing, investors seem to throw the odds out the window and prefer to play a very different game. One that is akin to the gambler at the roulette table. One where investment professionals try to outguess prices established by the collective wisdom of millions of different buyers and sellers each and every day.

Investors may be surprised by:

1) The number of investment funds that become obsolete over time, and

2) The low percentage of funds that are able to outperform their benchmark.

The chart below shows the sample number of funds that existed as at 31 December 2017, the number of funds that survived, and the number of funds that outperformed their benchmark. For example, 5 years ending 31 December 2017 (from 31 December 2012), there were 2,867 sample funds, of which 82% survived the 5 years, and only 26% were able to outperform their benchmark.

Source: Dimensional Fund Advisers (DFA)

Both survival and out-performance rates fall as the time horizon expands. For 15 years ending 31 December 2017, only 14% of funds survived and outperformed their benchmark. The odds of this game don’t seem very compelling if you ask me.

Let’s say you’ve found a manager who’s been able to outperform their benchmark for the last 3 years, and you’ve decided to hire them. Most investors and advisers use this method of manager selection, reasoning that a fund manager’s past success is likely to continue into the future – sack the poor performers, and hire the strong performers is how the narrative goes. The evidence suggests the contrary.

The chart below shows that among funds ranked in the top quartile (25%) based on previous three-year returns, most of them did not repeat their top-quartile ranking over the following. Over the periods studied, top-quartile persistence of three-year performers averaged 26%.

Source: DFA

The assumption that strong past performance will continue often proves faulty, leaving many investors disappointed. And despite all the evidence, investors continue to search for the winning investment – taking far greater risks than they ever expected.

Imagine for one second you could invest like the casinos. Putting the odds of success firmly in your favour the longer you play the game. As investors, we need to consider more than just a compelling story, and more than just good past performance. You may choose to ignore the evidence. You may choose to take on the odds. You may choose to ignore probabilities and make decisions based on predictions. Now that Paul the octopus is no longer with us, you may as well ask Achilles the cat for stock tips.