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Chapter 1: Gathering Intelligence

By: Investor Solutions

A good general gathers intelligence about the enemy prior to forming a strategy. A good investor gathers information about his friend, the market, before he forms his investment strategies. Fortunately for investors, gigabytes of useful market data are readily available for analysis.

The original process of gathering this data was a Herculean task. The laborers have never been properly recognized. We are all deeply in debt to researchers like Ibbotson and Sinqfield, organizations like the Center for Research in Securities Prices (CRISP), and hundreds of other individuals who worked in obscurity. The data they assembled is enormously valuable to us. With it we can begin to see clearly what is going on. With a “clean” database and a modern computer, researchers can sift and sort, analyze, and test their hypotheses. The forest, previously hidden by all those pesky leaves and trees, becomes visible.

Today we take this information for granted, but our grandfathers didn’t have anything like it. It wasn’t until the mid-’60s that a researcher was able to show that stocks outperformed bonds! And of course, we take our computers for granted. But they weren’t always there, either. The first primitive PCs were introduced less than 15 years ago. The average secretary’s 386 computer has more capacity than the US had during the entire Korean War. And 25 years ago, NASA put a man on the moon with far less computing capacity than my “old” 486 has.

Finally, all this information is instantly available worldwide. Investors no longer need to be at financial capitals. You or I can see trades at the same time that a trader in Hong Kong or New York does. And we have access to the same databases and research that Wall Street’s barons have. Our grandfathers couldn’t have even dreamed about these powerful tools. Often the results are surprising, and contradict the conventional wisdom. It’s up to us to adapt this new information and the insights we glean from it as we construct our Investment Strategies for the 21st Century.

Rates of Return

Investing is a multidimensional process. Of course, the first dimension is rate of return. The basic economic dilemma is this: Should we consume now or later? Given that our wants and needs are almost infinite, we have a strong preference for immediate consumption. Instant gratification isn’t a concept developed by the Yuppies.

If we are going to delay gratification, then most of us demand a reasonable prospect of payback and profit. Otherwise, we might as well enjoy it now.

A person seeking profit has a number of markets from which to choose. Cash, stocks and bonds are the traditional liquid markets which most of us first consider. But there are options, currencies, futures, commodities and other more exotic derivatives which are freely traded and totally liquid. Or an investor might want to consider real estate, fine artwork, baseball cards, stamps, coins or other valuable tangibles.

Each market, as we shall see, can be further broken down into smaller and smaller sub-markets. The list could become almost endless. And each little sub-market, or segment, would have distinct properties which an informed investor would want to understand before placing any funds. I am going to restrict myself to the traditional cash, stocks and bonds, and how we can form them into portfolios that will meet our needs.

The different markets have produced greatly different average rates of return over a long period of time. In the short term, on a fairly regular basis, markets will vary around the averages. These short-term variations are aberrations when viewed from the long-term perspective. Short periods of over- or under-performance are sooner or later reversed as the markets “regress to the mean.” Looking at the long-term data will give us a fair platform for evaluating markets. It gives us a powerful tool to estimate the “ranges of reasonableness” when we build or evaluate our portfolios.

Investors ignore this data at their peril.

We all know that if it sounds too good to be true, it probably is. Long-term data gives us the yardstick to measure whether something is too good to be true. You will buy a lot less pie in the sky if you keep this in mind.

Later we will see that individual investors are often their own worst enemies. Investor behavior can be extraordinarily shortsighted. Foolish investors insist on making their long-term decisions based on very recent experience. Lemming-like, they run from gloom and doom to euphoria. In the process, basic discipline flies out the window, and bad things happen to their investment results. Remembering long-term results can keep them from shooting themselves in the foot. A long-term outlook will stiffen resolve to stick with a well-thought-out investment plan.

Definitions

A few basic definitions are in order here:

The Consumer Price Index (CPI) is a commonly used measure of inflation. Inflation is the erosion of buying power over time, if dollars are used as a store of value. Investment returns must be adjusted by the inflation index in order for us to evaluate “real” returns. In other words, our returns must jump this hurdle in order to provide meaningful increases in value.

Treasury Bills (T-Bills) are short-term obligations issued by the United States government. Because they are guaranteed by the government, and the government can always print more dollars, they carry no credit risk. Treasury Bills are considered “zero-risk” in many academic discussions. We shall see that that is not always the case. T-Bills are a good proxy for many savings plans. They track CD rates reasonably closely.

Treasury Bonds are longer-term obligations of the government. They also carry no credit risk, but there is a substantial capital risk as interest rates change prior to redemption. An existing bond’s value changes inversely as interest rates change in the economy. We will talk lots more about bonds later. Commercial bonds are long-term debts issued by corporations. They carry both a default or credit risk, and a capital risk as interest rates change.

Commercial Bonds represent long-term debts of corporations. They are usually issued with a fixed interest rate (coupon) payable every 6 months. Bonds are generally issued with a maturity date, at which time they are redeemed for the face amount. While a commercial bond may default and become worthless, it can never be worth more than the face amount at maturity. The corporation has no other obligation other than to pay the interest and principal upon maturity. Bondholders generally have no say in the operation of the corporation unless the interest payment is in default. Bonds may be issued with specific assets of the corporation to back up the corporate debt, or as a general obligation of the firm.

Treasury Bills, Treasury Bonds, Commercial Bonds, Cash, Savings Accounts and CDs are all debt instruments.

Stocks represent ownership or equity in a corporation. Stocks may or may not pay a dividend. If a stock pays a dividend, it may change in amount from time to time and it is not guaranteed to continue. Like bonds, stocks may become worthless if a company fails. But unlike bonds, if the company prospers, there is no theoretical limit to the increase in value, and no redemption date. As owners of the corporation, stockholders are entitled to vote on the board of directors and may influence the operation of the company.

The S&P 500 is an unmanaged index of the largest 500 stocks on the New York Stock Exchange (NYSE). This index contains only mega-firms and is considered a good proxy for performance of the “blue chip” stocks.

Small cap stocks (as I’ll be referring to them) are the smallest 20% of the New York Stock Exchange-traded firms. (“Small” is a relative term. If a firm is traded on the NYSE, it has already reached a respectable size.)

The foregoing definitions are generalizations. My aim here is to keep this simple, and not get bogged down. Of course, there are hybrid instruments such as convertible bonds and preferred stocks. These securities have some of the properties of both stocks and bonds. If you want to know more, there are plenty of good finance books available, and I commend you for your interest. Check out my bookshelf in the archives. For now, let us move on.

A Look at the Long-Term Data

The following charts show performance data from 1926 to 1993. The data is extracted from Roger Ibbotson and Rex Sinqfield’s widely quoted annual book, Stocks, Bonds, Bills and Inflation. Compilation of this data has contributed greatly to the understanding we now have of how markets work.

First, let’s look at compound rates of return since 1926 in the broad domestic markets we just defined.

Chart

Next, let’s see how a dollar grew between 1926 and 1993. Due to the magic of compounding, what seems like a relatively small difference in rate of return will compound to giant differences in total accumulation. Look at the difference that 1.33% makes over time when we move from the S&P 500 to Small Company Stocks.

Chart

Next, to show real rates of return, we have subtracted out the average inflation rates. If we don’t account for inflation, we are just fooling ourselves. We want to be wealthier, not just have more inflated dollars!

Chart

In the real world, most of us pay taxes. Below, I show rates of return after inflation and reducing returns for an assumed 30% average tax rate. While we didn’t have an income tax the entire time, this comparison may still be far too kind to debt. For one thing, average marginal tax rates were often much higher during the period covered. For another, stocks offer the prospect of both deferral of tax and capital gains treatment, which I did not build into this simplistic model.

Chart

 

The Bottom Line

So, what can we learn from all this? Plenty!

The Range of Reasonableness

Long-term data gives us some very useful yardsticks.

The ’80s and early ’90s have been especially good to both stocks and bonds.

However, bad things happened to America in the ’70s. The Vietnam War divided the country, as an entire generation watched senseless violent death on national TV over dinner. Protesters took to the streets and grew violent themselves. Groups like the SLA and the Weathermen bombed, kidnapped, robbed and killed. The government became increasingly paranoid. The Nixon administration and Hoover’s FBI systematically violated our constitutional rights. The National Guard shot peaceful protesters on their college campus. A vice-president and president both resigned in disgrace, and narrowly missed jail. Nixon’s henchmen marched off one by one to prison. Democracy teetered on the brink.

On the economic front, things were just as bad. We charged the Vietnam War and Johnson’s Great Society. When the bill came due, OPEC cut off the oil. The government deficit mushroomed. Inflation soared, and interest rates climbed to unheard-of heights. American industry became bloated and could not compete effectively on the international markets. The stock market accurately reflected the turmoil. Returns in the ’70s could only be called dismal. During 1973-74 the S&P 500 dropped 50%. Bond investors were brutalized by rising interest rates.

The ’80s saw recovery. Over 20 years of concerted government policy steadily brought down inflation and interest rates. Industry painfully modernized and became competitive. Bond holders were finally rewarded by falling interest rates, and reaped rewards far in excess of coupon rates. Stock market returns rebounded after the lost decade. Even after two short “crashes” in 1986 and 1989, investors realized fantasy gains.

As a result, investors have come to expect rates of return which are greatly higher than the historical averages. I view these recent returns as an aberration. There is no data to indicate that either rates of return or risk premium (to be discussed in Chapter 2) have changed in any fundamental way. We are not all entitled to returns in the high teens or low 20s as a birthright. In any event, it seems foolish to project these rates on into the indefinite future.

Investors who view the ’80s returns as a yardstick may do themselves serious injury.

1. These investors can set themselves up to endlessly chase rainbows. As they fail to attain unrealistic goals, they often move from advisor to advisor or scheme to scheme, to their detriment. In the process, they inadvertently churn their own accounts. Wall Street is only too eager to help. The brokerage community is ever ready to promise far more than they can ever deliver to “get the business.” Investors who achieve, or advisors who deliver, “only” solid realistic results are at a distinct disadvantage in an atmosphere of hype and perfect 20/20 hindsight.

2. By placing faith in an accumulation plan based on a higher-than-realistic rate of return projection, these investors may be setting aside far too little to meet their long-term goals.

3. They also may be living off their nest eggs. Many establish withdrawal plans based on rates of return they cannot achieve in order to finance lifestyles they can no longer afford. They run the very real risk of causing their capital to implode, and they will become destitute in their old age.

Savings vs. Investment

Many academics might quibble, but I find it useful to distinguish between savings and investment. Savings might include all the debt instruments, cash, T-Bills, bonds, CDs, and annuities. Investments (equity) offer a long-term return sufficient to overcome inflation, and because they are traded each day, will fluctuate in value. If you don’t have both, you have a savings plan. (Fluctuation is a nice, non-threatening way to say that sometimes prices will go down! We really shouldn’t sugar-coat this little fact. It’s built right into the system. We will deal with fluctuation later.)

You will notice that the little boxes on the left of all the charts in this chapter represent debt or savings, while the tall, handsome boxes on the right represent equity. A saver who put a dollar into T-Bills in 1926, and who faithfully reinvested the proceeds for 68 years, actually saw his savings shrink to 70 cents on an after-tax, after-inflation basis! In other words, the dollar you put away in 1926, together with all the earnings on it, won’t buy as many Cokes or ice cream cones today.

As the data shows, savers must abandon hope of achieving an after-tax, after-inflation rate of return. Think of CD as standing for Constantly Diminishing. The stability of CDs does not translate into long-term security. Viewed from this perspective, the government-guaranteed savings plans are not wise, conservative or responsible. They are actually almost guaranteed to shrink in value! Even when interest rates are high, savings is a bankrupt investment policy. For instance, many savers fondly look back over the last 20 years of high interest rates. But even if all interest was re-invested, the after-tax, after-inflation rate of return on CDs from 1975 to 1994 was -1.85%! Interest rates are high during periods of inflation. A progressive tax eats away more at the higher nominal rates of return. Later we will examine how inflation ravages a fixed return over time. If a saver attempts to live off the interest on his nest egg, the results are catastrophic over time. He better hope not to live very long.

“Zero-risk” rates of return are very closely tied to inflation rates. So if you just want to keep up with inflation, you can accomplish that limited objective with debt instruments, but not much more. Most of us want an inflation hedge, growth and the ability to make withdrawals. Debt instruments haven’t been able to support that. Savings are a unique and treacherous form of capital punishment. Every day, millions of well-meaning savers unnecessarily punish their capital and prevent it from growing and thriving.

Another way to look at the data is to say that equity has returned about inflation plus 6-8%. Many advisors set the real rate of return as a long-term target. But anyone who builds his financial empire on a required rate of return of higher than 8% is skating on very thin ice indeed.

Long-term data gives us all a necessary “reality check.” Prudence and realism would dictate use of the more conservative data for planning. If we get more, we will all be pleasantly surprised.

No matter how you look at the data, equity returns swamp anything available in debt. Only equity offers investors the prospect of real rates of return.

So why isn’t everybody investing in equity? There must be more to it than this! The next chapter will deal with the investor’s four-letter word: risk.