John Rogers’ commentary for the third quarter 2014.
Recently, we have been concentrating on fundamentals—by rereading one of our favorite books, A Random Walk Down Wall Street, by Princeton professor Burton G. Malkiel. We highly recommend the 10th edition, which was revised in 2012. It remains a timeless, thoughtful meditation on efficient markets.
This great tome has become reduced and simplified to one notion in the popular imagination: Buy index funds. While it certainly helped launch passive investing, Random Walk contains a great deal more than one simple lesson. Ironically, the crucial insight embedded in its title all too often gets lost—the stock market follows a random walk. Dr. Malkiel writes: A random walk is one in which future steps or direction cannot be predicted on the basis of past history.
The latest Robinhood Investors Conference is in the books, and some hedge funds made an appearance at the conference. In a panel on hedge funds moderated by Maverick Capital's Lee Ainslie, Ricky Sandler of Eminence Capital, Gaurav Kapadia of XN and Glen Kacher of Light Street discussed their own hedge funds and various aspects of Read More
When the term is applied to the stock market, it means that short-run changes in stock prices are unpredictable.
John Rogers: “Do not try to time the market” is an important foundation
While conventional wisdom says the book’s most critical lesson is “passive not active,” we think “do not try to time the market” is an even more important foundation. That is, trying to use recent market returns to guide your investments is a poor plan. October 2014 provided a great test case.
Now that the month is finished, we can summarize it fairly easily. Over its 24 trading days, the large-cap S&P 500 Index gained +2.44%, the foreign MSCI EAFE Index slid -1.45%, and the small-cap Russell 2000 Index surged +6.59%. The month, however, was essentially split in half: falling markets in the first 12 sessions and a rally in the later 12. The table below shows the summary of results.
John Rogers: Market sell-off in October
Attempts to time the market involve two impulses: trying to opportunistically buy near the bottom and defensively selling to avoid (further) losses. October 2014 nicely illustrates the difficulty of such attempts. Say a “sell discipline” involves exiting an asset class if it drops more than -5% within a given month. Such an investor might have sold U.S. large caps and foreign fare at mid-month, missing out on the great gains in the second half. On the other hand, suppose a different investor decides to buy into an asset class only when it loses -5%. He or she might have captured the gains of large caps and foreign fare but likely would have missed the stellar two-week gain in small caps.
The lesson October exemplifies is exactly what Malkiel noted: The market does not dependably signal continuity or discontinuity— market returns are unpredictable even if they seem telling. Moreover, as Benoit Mandelbrot argues in The (Mis)Behavior of Markets, stock charts are fractals, “a pattern or shape whose parts echo the whole.”2 If you remove the labels from the charts, a one-day stock chart resembles a one-month stock chart, which looks like a one-year chart or a one-decade chart. The lesson of October also applies to the past 12 months. Here are the returns:
The monthly index returns do not track each other, nor do they have internal patterns. The S&P 500 Index had a run of five straight months of gains, but the Russell 2000 Index had two down months during that stretch and the MSCI EAFE Index had one. The MSCI EAFE Index had flat performance overall, with six monthly gains and six monthly losses. We see no pattern that would foretell the four-month losing stretch at the end. Moreover, no one knows what the November return will be—a fifth straight loss or a streak-breaker. We would also note the herky-jerky pattern of small caps from July through October; buying or selling during such a period could quickly create regret.
John Rogers’ investing strategy
Few would argue it is safe or sensible to drive while staring at the rear-view mirror. Rather one must look forward and have a prudent plan: drive at the speed limit, making necessary adjustments along the way. In investing, that means creating an asset allocation policy that conforms to your financial needs and risk tolerance, and then keeping your portfolio reasonably close to plan. That is altogether different from ignoring your asset mix and trying to guess when the market will hit bottom.
Past performance is no guarantee of future results. The opinions expressed are current as of the date of this commentary but are subject to change. The details offered in this commentary do not provide information reasonably sufficient upon which to base an investment decision and should not be considered a recommendation to purchase or sell any particular security.
John Rogers: Risks in equity stocks
Investing in equity stocks is risky and subject to the volatility of the markets. Investing in micro-, small and mid-size companies is more risky and more volatile than investing in large companies.
Investments in foreign securities may underperform and may be more volatile than comparable U.S. stocks because of the risks involving foreign economies and markets, foreign political systems, foreign regulatory standards, foreign currencies, and taxes. Investments in emerging and developing markets present additional risks, such as difficulties in selling on a timely basis and at an acceptable price.
Indexes are unmanaged. Investors cannot invest directly in an index. The Russell 2000® Index measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000® Index is a subset of the Russell 3000® Index, representing approximately 8% of the total market capitalization of that index. It includes approximately 2,000 of the smallest securities on the basis of a combination of their market cap and current index membership. Russell® is a trademark of Russell Investment Group, which is the source and owner of the Russell Indexes’ trademarks, service marks and copyrights. The S&P 500® Index is the most widely accepted barometer of the market. It includes 500 blue chip, large-cap stocks, which together represent about 75% of the total U.S. equities market. The MSCI EAFE® Index is an unmanaged, market-weighted index of companies in developed markets, excluding the United States and Canada. The MSCI EAFE® Index (gross) returns reflect the reinvestment of income and other earnings, including the maximum possible dividends. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used to create indexes or financial products. This report is not approved or produced by MSCI. (Source: MSCI.)