Sweet Surrender

Success in any 12-Step Program requires that the addict accept their powerlessness against their addiction, and to essentially surrender to a higher power — one that can lead them on their path to success.

For active investors, this higher power is the wealth of knowledge, research and empirical evidence that is the cornerstone of prudent and successful investing. In fact, so meaningful is this research, that many of the developers of sound, peer-reviewed financial research have won Nobel Prizes for their groundbreaking findings.

If an investor hopes to invest for a brighter future, the quality of the information they use to render a decision is imperative — higher-quality information and longer-term datasets will make for sound investments that carry expected returns and a higher probability of achieving that return. The key point here is the value of long-term data — and the longer-term, the better.  Unfortunately, recommendations based on short-term data are the faire du jour for 90% of the information that fills the internet, airwaves, newspapers, magazines, and of course, the ever-irritating CNBC.

Many investors may see through this veneer of “news” which in reality is thinly veiled advertising from high-paying sponsors to induce investors to trade--and often. However, many who are wise to this shell-game, might be surprised to find analysts’ reports are not much better when it comes to reliable advice from a trustworthy source.
Case in point. Toyota (once again) came under fire earlier this week when internal documents were discovered that claimed the car company saved $100 million in recalls by obtaining a limited recall from regulators in 2007. Was it this news that prompted analysts to issue an “overweight” rating on the stock it the spring of 2007, and giving it a price target of $151?  That stock was in the low 70’s last time we looked. 

To further this point, following analysts’ recommendations on AIG Group would have annihilated an investor’s portfolio. In the three months prior to September 2008 (when AIG was given an initial $85 billion in bailouts), Citigroup, BofA, and UBS all gave this company a “Buy” recommendation. The former behemoth Wachovia gave it a market- perform rating. They were all very wrong, and investors who trusted them lost a huge amount of money. On September 8, 2008, that stock traded at $24. By Sept. 16 (just 8 days later), it was trading at $1.80.

Morningstar recommendations are an equally untrustworthy source of reliable information for investors. An example: In 1999, Legg Mason Value Trust manager Bill Miller was named "Fund Manager of the Decade" by Morningstar — a distinction which carried with it Morningstar's highest rating of five stars. Miller had beaten the S&P for 15 straight years and as far as short-term data followers were concerned, this guy was unstoppable – that is until he stopped and actually went into reverse, taking his shareholders’ returns along for a very painful retrenchment which actually saw investors in 2008 underperform the S&P 500 by a whopping 20 percentage points—losing 58% in that year according to the Wall Street Journal.  Massive losses and a steady stream of redemptions from individuals and state pension plans alike shrank the fund by a whopping 75% in just one-year’s time. Ouch.

The Higher Power for Investors

The reason why traders who pick stocks, funds, time markets etc. fail over time is because markets are both random and efficient. These observations, research and groundbreaking discoveries made financial economist Eugene Fama a noteworthy frontrunner for a Nobel Prize in Economics. In helping to define what this really means, Fama said, “It’s a very simple concept. It says that prices basically reflect all available information so that in a strict view of the theory it would say it’s basically impossible to beat the market. You’re always paying a fair price, basically.”  Watch Eugene Fama talk more about the efficient market here.

Fama’s ongoing and in-depth research about how markets work is a continuation of the  Nobel Prize Winning research of noted economists the likes of William Sharpe, Merton Miller, Paul Samuelson and Harry Markowitz. Each earned his prize for ground-breaking discoveries about the market and the true source of stock market returns. Their findings are not messages that big brokerage houses will allocate big ad budgets to because they simply tell you to STOP TRADING.  
 

1. Specifically, Sharpe quantified the risk premium of being in the market as opposed to T-bills. He said if you hold the market portfolio, you will earn the market’s rate of return.
2. Harry Markowitz advised that you simply can’t look for the highest returning investment and not consider the risk of that investment. Today, we look at hedge funds and their leverage. Think about it. If you have 10 to 1 leverage—not uncommon in hedge funds—it only takes a 10% decline before that investment is wiped out. Most people can’t handle that sort of risk—and by the way—NO ONE should take that kind of risk. It was Harry Markowitz’s risk reward optimization chart that actually allowed investors to plot their investments’ risk and reward data against all the other available investments to determine the validity of the risk. Most people don’t do this though, so they have absolutely no idea how much risk they are taking until it is too late—as was the case with AIG. By the way, individual companies carry at least twice as much risk as the index, but carry no increased expected return above the market—making all individual companies very bad investments.
3. Merton Miller determined a company’s cost of capital is returned to the shareholder. This enables us to establish an expected return—and guess what? The riskier companies carry a higher expected return.

Learning about the contributions of Nobel Laureates and other academics increases an investor's risk capacity and every incremental point in your risk capacity score carries with it an incremental increase in expected return (see the New Figure 3 for IFA Index Portfolio 90) . With a twist on "The Beatles" famous verse from "The End" on the Abbey Road album, investors could say, "And in the end, the return you make is equal to the risk you take."