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Saturday, July 25, 2009

Views of a Contrary Investor

I see discussions of short term percentage gain or loss in investing all the time. I rarely see similar long term discussions. Important? Maybe not. But is the fact that there is simple asymmetry between percentage gains and losses actually considered? If it really was, I think a fair number of investors would change their thinking, at least a bit.

If you invest for two years, one up 10% and one down 10% (either order) you end up losing 1%. If you had twice the variability (up 20%, down 20%), you end up losing 4%. If you have a real rollercoaster ride like we’ve had recently and have a +40% and -40% year, you end up losing 16%. And that’s just in a two year time frame. Over a couple decades or so, this is no small matter.

Here’s a different example. Suppose you had five and a half years in which you had an annual return of +24%. But you also had 4 years of -30% performance. 5.5 years compared to 4 years is a bigger ratio than 30% to 24%, so it could look close to a wash on first blush. Actually you’d end up with a loss of 36%. I didn’t pick these numbers randomly. They’re the combined rates of return for the two cyclical bull and two cyclical bear cycles for the S&P 500 in the current secular bear market (counting the last 4+ months as the second bull cycle) since March 2000. For retirees the loss is even worse because nearly a decade has been lost too, and there’s much less time to make it up.

It’s been noted that there’s a fine line between investing and gambling. It’s also been noted that gamblers as a whole notoriously inaccurately report their betting results. This is true even though they know the games are all rigged and casinos very consistently report gaming profits. I’m only suggesting that there’s a psychological driver that can keep us from being objective when it comes to some numbers.

Focus on the short term is the name of the game for TA. It can work well, until it doesn’t. The trends and indicators traders use can be useful for the well informed, and there are people making a lot of money using it. But it’s a combination of skill and getting more right calls than wrong ones, because technicals simply change at some point and go in another direction. They always do that at some point whenever they have been going in a direction for some time that the fundamentals aren’t going in. Ironically, the longer term you use in TA the better the predictive power. I recall seeing a discipline using the 20 and 50 week moving avg. which would only involve trading every few years. It actually resulted in very few bad signals.

But if you go out to the very long term, you can find very durable trends that you can use to guide you. The problem of course is that all of this takes a lot of patience. I suspect, more than anything else, the gambling/investing crossover has some merit here. Gambling is done to make money quickly or at least to have fun. The most successful long term investors tell us success comes with patience and discipline. Now there’s a conflict.

The most useful long term trend I know about is the two century pattern of secular market oscillation. The characteristics of the trend are that the length is fairly uniform, and the investment results over for the opposing cycles are hugely different. In other words you could reliably make money for years during one phase of the cycle and avoid most of the loss in the other phase of the cycle. But very few people have any interest in this phenomenon and it basically gets ignored.

The other very useful long term trend I know of is the fact that the variance in performance of a given security is due much more to the variance of its asset class than its individual characteristics. And the variance in performance of a given asset class is much more due to the variance in the economic fundaments than characteristic differences from other classes. So the greatest bang for the DD buck in the long run is to learn about the big things. This too is pretty unappealing. None of this is any fun. And it takes too long to get any results.

A knowledge of secular market history and characteristics would put a lot of beliefs and myths into a better perspective IMO. We live and work in a shorter time frame, and get our expectations conditioned accordingly. In the last secular bull market (1982-2000), the only cyclical bear market was the very brief one because of the 1987 crash. 17 plus years of bull market and a few months of bear market. Everybody was making money, especially the risk takers. But to a lesser extent, the same thing was true of the prior secular bull market (1949 – 1966) – 15 years of bull market and only 2 yrs. of bear market.

But the secular bear markets are a long tough grind, which have the added characteristic of being cruel because there is actually more bull market time in them than bear market time. In the intervening secular bear market (1966 – 1982), there was 6.7 yrs. of cyclical bear market but 9.7 years of cyclical bull market.

Maybe surprisingly, the compound annual growth rate for the bear years was almost the mirror image of the bull years (-21% vs. +20%). But as you might guess the result wasn’t a real gain because of how percentages work against you. Actually the overall CAGR was about +0.6%. But there’s nothing positive about 17 years of almost no nominal gain in the face of rapidly rising inflation. Real gain was distinctly negative.

Even in the current secular bear market (2000- present), there has been the 5.5 years I mentioned of cyclical bull market and “only” a bit under 4 years of cyclical bear market. Small consolation, and again cruel, as cyclical thinking still has investors with a shorter term outlook anticipating a fairly timely recovery of the lost ground.

A few years ago I posted in other places a number of times about my deep concern with the long term investing environment we were in. I took some real criticism for being so conservative and being satisfied with trying to earn no more than an 8% return while the domestic equity market was turning out a 14% gain.

I have nothing that isn’t obvious to suggest as a way to achieve good long term results.. But here goes. It really does take more to make up a loss than it took to make it the first time, so don’t lose it. The best investment advisors are the ones with the longest experience. Pay attention to the big picture, even study it. Of course the real world consists of an overwhelming number of market participants with a short term outlook, people trying to make money quickly, and most of the attention focused on bottom up thinking. This is after all a post from a contrarian investor.

joatmon

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